Question

QUESTION THREE [25]

3.1 Questions 3.1.1 to 3.1.2 are based on the excerpt below: When envisioning and establishing her business, Ntiki focused on both, the short-term and long-term goals. Her short-term goal was to outgrow local competitors. She knew she wanted to eventually compete with the large number of relatively small firms in the industry, but first needed to examine her strengths and weaknesses. Ntiki distinguished her business by analysing the industry, focusing on customer service and advertising.

3.1.1 Discuss the type of market structure that Ntiki is operating in. (12)

3.1.2 Explain the long-run equilibrium position of firms operating in this market structure. Motivate your answer with the aid of a diagram

Answer 1

3.1.1) Ntiki is operating in a monopolistically competitive market structure. In a monopolistically competitive market, there are a large number of small firms, with each firm selling somewhat differentiated product from it's competitors but close close substitutes to the product sold by other sellers. To differentiate it's product from other sellers, a monopolistically competitive firm indulges in advertising and focuses on customer care service to differentiate itself from other sellers. As Ntiki distinguished her business by analyzing the industry, focusing on customer care and advertising, it clearly states that Ntiki is operating in a monopolistically competitive market.

3.1.2 ) A monopolistically competitive market is characterised by free entry and exit. It means that firms can enter or leave the industry as per their desire. If existing firms are earning positive economic profits in the short run, then new firms will be attracted to enter the industry in the long run and earn these economic profits. As such new firms will enter the industry. As new firms will enter, the demand for existing firms will decrease and demand curve will shift to the left. This entry of new firms will continue to take place until demand curve becomes tangent to average total cost curve and all the firms earn normal profits only i.e., just covering their costs. If the existing firms are incurring losses in the short run, firms would like to exit the industry in the long run. As firms will exit, the Demand for existing firms will increase. As demand will increase, the Demand curve will shift to the right. This exit of firms will continue to take place until demand curve becomes tangent to average total cost curve and all the losses are eliminated and firms earn normal Profits only i.e., just covering their costs. Hence, in the long run, monopolistically competitive firms earn normal Profits only i.e., just covering their costs.

In the above diagram, the monopolistically competitive firm is in long run equilibrium. The firm will produce that level of output where marginal cost is equal to marginal revenue at point E. The output produced is Q . This is the profit maximising output. At this level of output, the Demand curve D lies tangent to average total cost curve AC. This implies that the price charged is equal to the average total cost and the firm is earning normal profits only i.e., just covering their costs.