Chapter 11: Problem 5

In the long run a firm under monopolistic competition faces a no-economic profit no-loss situation.

Short Answer

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Answer: A firm under monopolistic competition faces a no-economic profit no-loss situation in the long run due to the entry and exit of firms in the market, which increases competition and eliminates economic profits. In the long run, the price set by a monopolistically competitive firm will be equal to its average total cost, and the firm will earn zero economic profit. This outcome is a result of the equilibrium between the upward pressure on price from market power and the downward pressure on price from competition.

Step by step solution

Monopolistic Competition

Monopolistic competition is a market structure where there are many firms producing differentiated products. Each firm has some degree of market power due to product differentiation, meaning that firms can set prices above their marginal cost. However, there is still competition among the firms, which prevents them from earning significant long-term economic profits.

Entry and Exit of Firms

One of the key characteristics of monopolistic competition is the freedom of entry and exit for firms. If a firm in the monopolistically competitive industry is experiencing economic profits, it attracts new firms to enter the market. As more firms enter the market, competition increases and the demand curve for each firm's product becomes more elastic, leading to lower prices and decreased economic profits for all firms.

Long-run Equilibrium

In the long run, firms in monopolistic competition will reach a point where they earn zero economic profit, which is also known as a no-economic profit no-loss situation. This occurs when the downward pressure on price due to increased competition is equal to the upward pressure on price due to each firm's market power. At this point, each firm's price is equal to its average total cost (ATC) - including opportunity cost - and no economic profit is earned.

Graphical Representation

In a graph representing a monopolistically competitive firm, the demand curve (D) is downward-sloping due to product differentiation. The marginal revenue (MR) curve will lie below the demand curve, as the firm needs to lower its price to sell additional units. In the long run, the demand curve will be tangent to the average total cost (ATC) curve at the profit-maximizing output level, where marginal cost (MC) intersects the marginal revenue (MR) curve. This tangency point represents the no-economic profit no-loss situation, as the firm's price equals its average total cost.

Conclusion

In conclusion, a firm under monopolistic competition faces a no-economic profit no-loss situation in the long run due to the entry and exit of firms, which increases competition and eliminates economic profits. In the long run, the price set by a monopolistically competitive firm will be equal to its average total cost, and the firm will earn zero economic profit. This outcome is a result of the equilibrium between the upward pressure on price from market power and the downward pressure on price from competition.