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Chapter 13: Problem 7

(Related to the Don't Let This Happen to You on page 458) A student remarks: If firms in a monopolistically competitive industry are earning an economic profit, new firms will enter the industry. Eventually, a representative firm will find that its demand curve has shifted to the left until it is just tangent to its average total cost curve and the firm is earning zero profit. Because firms are earning zero profit at that point, some firms will leave the industry, and the representative firm will find that its demand curve will shift to the right. In long-run equilibrium, price will be above average total cost by just enough so that each firm is just breaking even. Briefly explain whether you agree with this analysis.

Short Answer

Expert verified
The analysis made by the student is partially correct with the process of entry of new firms until the firm's demand curve becomes tangent to the average total cost curve. However, the assumption that firms will leave the industry when zero profit occurs, might not always hold true, especially in the long run. In the long-run equilibrium, contrary to the assertion made by the student, the price will not be above average total, rather it will be equal to the average total cost ensuring the firm is just covering its costs.

Step by step solution

01

Understanding the entry of firms

In a monopolistically competitive industry when firms are earning an economic profit, it is true that new firms get attracted and enter the industry, thus increasing the competition.
02

Effect on demand curve

This increase in competition tends to shift the demand curve of an individual firm to the left as the consumers now have more options to fulfill their demands.
03

The tangent point of demand and average total cost curve

The demand curve would continue to shift left until it becomes tangent to the firm's average total cost curve which implies that firm is now just breaking even and not making any economic profit.
04

Exit of firms and its impact

The assumption that firms will leave the industry when zero profits are being made might not always be correct, specifically in the long run. This is because firms consider their sunk costs and still operate to cover their variable costs.
05

Long-run equilibrium

In the long-run equilibrium, the price will be tangential to the average total cost, implying the firm is just covering its costs. This contradicts the statement that price will be above the average total cost in equilibrium.

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