Question

If the firms in a monopolistically competitive market are earning economic profits or losses in the short run, would you expect them to continue doing so in the long run? Why?

Short answer

No, firms in a monopolistically competitive market will not continue to make economic profits or losses in the long run that they make in the short run. This is because of the free entry and exit of firms in this market structure. In the long run, the presence of economic profits attracts new firms, increasing competition and reducing prices, eroding profits. Similarly, economic losses lead to firms exiting the market, reducing competition and raising prices for the remaining firms, eliminating losses. Ultimately, in the long run, each firm will earn normal profits, where total revenue equals total economic cost.

Step-by-step solution

Understanding Monopolistic Competition

Monopolistic competition is a market structure characterized by a large number of small firms, product differentiation, freedom of entry and exit, and independent decision making. Each firm under monopolistic competition has a slightly differentiated product, giving them some control over their pricing. However, in the long run, they do not have substantial market power due to free entry and exit in the industry.

Understanding Economic Profits and Losses

In the short run, firms in a monopolistic competition market may earn profits or incur losses depending on their costs and revenue. Economic profit occurs when total revenue exceeds total economic cost (including both explicit and implicit costs). In contrast, economic losses occur when total economic cost exceeds total revenue.

Short Run Profits or Losses in Monopolistic Competition

In a monopolistically competitive market, firms can make short run profits due to their product differentiation and the resulting ability to charge a price above marginal cost. On the other hand, firms may make losses when their total costs exceed their total revenue.

Explaining Long Run Dynamics in Monopolistic Competition

According to the theory of monopolistic competition, in the long run, firms will not continue to make economic profits or losses that they may have in the short run. If the firms are making profits, other firms are attracted by these profits and enter the market. This increases the competition in the market, reducing the demand and subsequently the price for existing firms, leading to a reduction in profits. The process continues until all the economic profits are eroded. On the other hand, if companies incur losses, some firms will exit the industry, reducing the competition, and raising the price for remaining firms. This process will continue until all economic losses are wiped out. Hence, in the long run, each firm, in a monopolistically competitive market will tend to earn only normal profits, which is a situation where total revenue equals total economic cost.

Conclusion

So, the answer to the given problem is that, no, the firms in a monopolistically competitive market will not continue to make economic profits or losses they make in the short run in the long run due to the characteristics of this market structure, specifically free entry and exit, which lead to normal profits in the long run regardless of short run conditions.