Question

Under a monopolistic competition model with increasing returns to scale, how would equilibrium differ when the different varieties are closer substitutes for each other compared to when the varieties are not as close substitutes? Explain

Answer 1

Monopolistic competition characterizes an industry in which many firms offer products or services that are similar, but not perfect substitutes. Barriers to entry and exit in a monopolistic competitive industry are low, and the decisions of any one firm do not directly affect those of its competitors. Monopolistic competition is closely related to the business strategy of brand differentiation.

To the far right of the market structure continuum is monopoly, characterized by a single competitor and extensive market control. Monopoly contains a single seller of a unique product with no close substitutes. The demand for monopoly output is THE market demand.

In the long run, with all inputs variable, a monopolistically competitive industry reaches equilibrium at an output that generates economies of scale or increasing returns to scale. At this level of output, the negatively-sloped demand curve is tangent to the negatively-sloped segment of the long run-average cost curve.

This is achieved through a two-fold adjustment process.

• The first of the folds is entry and exit of firms into and out of the industry. This ensures that firms earn zero economic profit and that price is equal to average cost.
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• The second of the folds is the pursuit of profit maximization by each firm in the industry. This ensures that firms produce the quantity of output that equates marginal revenue with short-run and long-run marginal cost.