Question

Question 1 :

1. What effect does the entry of new firms have on the economic profits of existing firms in a monopolistically competitive market? Elaborate your answer with appropriate examples.
2. Why a firm remains in business even by earning zero economic profit? Elaborate your answer.

Answer 1

Entry of new firms in monopolistic competition :-

The firm under monopolistic competition earn supernormal profits in short run as they sell the quantity where the marginal revenue curve is intersecting the marginal cost curve however the price charged by them is much higher than their average cost because the average cost curve lies below the average revenue curve leading to supernormal profit in short run.

Unlike Monopoly, there are no barriers to entry for the firms. This means the supernormal profit that is being earned by the existing firms attract new producers into the market which shift the demand curve to the left as a consumers choose to buy product by the new or alternative companies.

This leads to reduction in supernormal profits for all the firms that are existing in the market. The demand curve continues to move left until it becomes tangent to average cost curve. At this point the monopolistic competitive firms are at the profit maximizing level of output as the marginal revenue is equal to the marginal cost and the firms are making a normal profit because the average revenue curve becomes equal to the average cost curve.

If more firm's enter the market the existing firms will start to earn supernormal losses leading to exit of some of the firms and bringing back the the market equilibrium to normal profit output level.

Condition of zero economic profit :-

Total cost of the firm includes opportunity cost of the firm as well. Accounting profit is the combination of normal profit and economic profit. When a firm is earning zero economic profit that does not mean that the accounting profit of the firm is also zero. Thus even when the firm is at zero economic profit level it is still earning profits in order for it to stay in the business.