Model Answer
0 min readIntroduction
Monopolistic competition is a market structure characterized by a large number of sellers, differentiated products, and relatively easy entry and exit. Unlike perfect competition, firms have some control over price due to product differentiation, but unlike monopoly, this control is limited by the presence of many close substitutes. This structure is prevalent in many real-world markets, such as restaurants, clothing, and retail trade. Understanding the short-run and long-run equilibrium of a firm under monopolistic competition is crucial for analyzing its profitability and market dynamics. This answer will detail these equilibrium conditions, highlighting the key differences and implications.
Short-Run Equilibrium
In the short run, a firm under monopolistic competition behaves much like a monopolist. It aims to maximize profits by producing at the output level where Marginal Revenue (MR) equals Marginal Cost (MC). The firm faces a downward-sloping demand curve due to product differentiation, allowing it to set its price. However, this price is constrained by the availability of close substitutes.
- Profit Maximization: MR = MC determines the profit-maximizing quantity (Q*).
- Price Determination: The firm charges a price (P*) based on the demand curve at Q*.
- Profit/Loss: The firm can earn economic profits, incur losses, or break even in the short run. This depends on whether P* > Average Total Cost (ATC) at Q*.
Graphical Representation: A typical short-run equilibrium diagram will show a downward-sloping demand curve, a downward-sloping MR curve, and an upward-sloping MC curve. The intersection of MR and MC determines Q*, and the corresponding price P* is found on the demand curve. If P* is above ATC at Q*, the firm earns a profit; if below, it incurs a loss.
Long-Run Equilibrium
The long run is characterized by free entry and exit. The presence of economic profits in the short run attracts new firms into the industry. This increases the number of substitutes available, shifting the demand curve for the existing firm to the left and making it more elastic. Conversely, losses in the short run cause firms to exit, reducing the number of substitutes and shifting the demand curve for the remaining firms to the right.
- Entry/Exit: Free entry and exit drive economic profits to zero in the long run.
- Demand Curve Shift: Entry shifts the demand curve left; exit shifts it right.
- Tangency Condition: In long-run equilibrium, the demand curve is tangent to the Average Total Cost (ATC) curve at the profit-maximizing output level.
- P = ATC: This tangency implies that price equals average total cost, resulting in zero economic profit.
- Excess Capacity: Firms operate with excess capacity, meaning they are not producing at the minimum point of their ATC curve. This is a key characteristic of monopolistic competition.
Graphical Representation: The long-run equilibrium diagram shows the demand curve tangent to the ATC curve at Q*. At this point, P = ATC, and the firm earns zero economic profit. The output level Q* is less than the output level that would minimize ATC, illustrating excess capacity.
Comparison: Short-Run vs. Long-Run
| Feature | Short-Run | Long-Run |
|---|---|---|
| Economic Profit | Positive, Negative, or Zero | Zero |
| Number of Firms | Fixed | Adjusts due to entry/exit |
| Demand Curve | Downward sloping | Downward sloping, more elastic |
| Price (P) | P > MC | P = ATC |
| Capacity | May be operating at optimal capacity | Excess Capacity |
Product Differentiation and Advertising: Firms in monopolistic competition rely heavily on product differentiation and advertising to maintain their market share. Advertising aims to make the demand curve for their product less elastic, allowing them to charge a higher price. This is a continuous process as new firms enter and existing firms strive to maintain their competitive edge.
Conclusion
In conclusion, the short-run equilibrium of a firm under monopolistic competition allows for the possibility of economic profits or losses, while the long-run equilibrium, driven by free entry and exit, results in zero economic profit and excess capacity. This market structure represents a compromise between the efficiency of perfect competition and the market power of monopoly. Understanding these equilibrium conditions is vital for analyzing the behavior of firms in a wide range of industries and for formulating appropriate policy interventions. The constant need for product differentiation and advertising highlights the dynamic nature of these markets.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.