Question

Suppose the market for breakfast cereals is best described by monopolistic competition. In the short run, firms are earning positive profits. In a few sentences, explain the dynamics that capture how the market – at both the industry level and at the firm level – reach long‐run equilibrium. Be clear about market forces and firm decisions.

Answer 1

The monopolistic competitive market is characterized by large number of firms producing something differentiated products but is close substitutes to each other. Since product differentiation exists each firm has some sort of monopoly power over its products. But the products are close substitutes so the firm has to face competition from the rivals. A firm under this market faces a downward sloping demand curve which is more elastic than monopoly but less elastic than a competitive firm.

In shortrun and longrun the firm choose to produce a level of output where it’s MC=MR. If marginal revenue is greater than the marginal cost the firm will expand output and if the marginal revenue is less than the marginal cost the firm will reduce the output. Thus the optimum output of the firm is a point of equality between MC and MR.

The profit or loss depends upon the difference between the average cost and market price. If the average total cost is below the market price the firms will earn positive profit. On the other if the average cost is above the market price the firm will incur loss.

If the firms in this market earn positive profit in shortrun, this positive profit will replaced by normal profit by the entry of new firms into the market. Since there is freedom of entry of new firms into the market, new firm will enter into the market in longrun. The demand curve of the monopolist is more elastic in longrun since new firms enter into the market with close substitutes. The entry of new firms increases the market supply and reduces the market price. Gradually this super normal profit will be eliminated at all firms will earn only normal profit. Thus a condition will reach where the firm’s equilibrium is reached where price = ATC and MC=MR.