Chapter 10: Problem 2

Continuing with the scenario in question \(1,\) in the long run, the positive economic profits that the monopolistic competitor eams will attract a response either from existing firms in the industry or firms outside. As those firms capture the original firm's profit, what will happen to the original firm's profit-maximizing price and output levels?

Short Answer

Expert verified

In the long run, the positive economic profits of a monopolistic competitor attract new firms to the industry, increasing competition. This leads to a decrease in demand for the original firm's product, forcing the firm to reduce its price and output. The profit-maximizing price and output levels for the original firm will eventually adjust to a new equilibrium where the firm earns zero economic profit, with the price equal to its average total cost, and output at its profit-maximizing quantity.

Step by step solution

Understanding the monopolistic competition market structure

Monopolistic competition is a market structure characterized by a large number of firms selling differentiated products. In this market, firms have some market power, allowing them to set prices above marginal cost, but not as much as in a monopoly. The key features of monopolistic competition include product differentiation, freedom of entry and exit, and many firms in the industry.

Reviewing the factors that lead to positive economic profits

Positive economic profits occur when a firm's total revenue exceeds its total cost, including both explicit and implicit costs. In the short run, a monopolistically competitive firm can earn positive economic profits if it can set a price higher than its average total cost due to product differentiation and some degree of market power. This typically happens when the firm is producing a product that is in strong demand and has limited competition.

Analyzing the impact of positive economic profits on the industry

In the long run, the positive economic profits earned by the monopolistic competitor will attract other firms either from existing firms in the industry or firms outside the industry. This increased competition will have two main effects: 1) The demand for the original firm's product will decrease as consumers have more choices, and 2) The average total cost for all firms in the industry will likely decrease as they take advantage of economies of scale or other cost-saving measures.

Determining the profit-maximizing price and output levels in the long run

As competition increases and firms capture the original firm's profit, the original firm's demand curve shifts leftward and becomes more elastic. This will force the original firm to reduce its price and output. In the long run, the firm will continue to adjust its price and output until it reaches a new equilibrium where it earns zero economic profit. At this point, the firm's price will equal its average total cost, and its output will match its profit-maximizing quantity.

Conclusion

In the long run, the positive economic profits of a monopolistic competitor will attract new firms to the industry, increasing competition. This will lead to a decrease in demand for the original firm's product, forcing the firm to reduce its price and output. The profit-maximizing price and output levels for the original firm will eventually adjust to a new equilibrium where the firm earns zero economic profit, with the price equal to its average total cost, and output at its profit-maximizing quantity.

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