Chapter 13: Problem 3

Under what circumstances might a monopolistically competitive firm continue to earn an economic profit as new firms enter its market?

Short Answer

Expert verified

A monopolistically competitive firm might continue earning economic profit as new firms enter its market if barriers to entry exist, if it can differentiate its product significantly from competitors, and if it can maintain a counterbalancing high quality of product or service.

Step by step solution

Define monopolistic competition

Monopolistic competition is a market structure where a large number of firms sell closely related, but not identical, products. There is free entry and exit, and each firm makes independent decisions about price and output, based on its product, its market, and its costs of production.

Understand the conditions for earning profit

A monopolistically competitive firm can continue to earn economic profit in the long run under several conditions: (1) when there are barriers to entry making it difficult for new firms to get into the market, (2) when the firm can constantly innovate and differentiate their product from competitors, and (3) when there are loyal customers who are less sensitive to price increases.

Consider the role of product differentiation

Product differentiation can be a major factor for a monopolistically competitive firm to continue earning profit. The firm can differentiate their product design, quality, after-sale service etc. to make customers believe their product is superior and therefore they are willing to pay more.

Consider the quality of product or service

Customers associate the firm's product with higher quality as compared to it's competitors. This higher perceived quality allows the firm to charge a higher price for its product, thus maintaining profitability.

Reflect on barriers to entry

Barriers to entry also can maintain a firm's economic profit in long run. These barriers may include exclusive access to a scarce resource, government regulation, high startup costs, or superior technology.