Question

Under monopolistic competition, the long period firm demand curve is theoretically problematical because of interdependency. How is this problem resolved?

Answer 1

Monopolistic competition is a market structure which combines elements of monopoly and competitive markets. Essentially a monopolistic competitive market is one with freedom of entry and exit, but firms can differentiate their products. Therefore, they have an inelastic demand curve and so they can set prices. However, because there is freedom of entry, supernormal profits will encourage more firms to enter the market leading to normal profits in the long run.

A Monopolistic competitive industry has the following features:-

(i) Many Firms.

(ii) Freedom of entry and exit.

(iii) Firms produce differentiated products.

(iv) Firms have price inelastic demand, they are Price makers because the good is highly differentiated.

(v) Firms make normal profits in the long run but could make supernormal profits in the short term.

(vi) Firms are productively inefficient.

The demand curve as faced by a monopolistic competitor is not flat, but rather downward sloping, which means that the monopolistic competitor can raise its price without losing all of its customers or lower the price and gain more customers. Since there are substitutes, the demand curve facing a monopolistic competitive firm is more elastic than that of a monopoly where there are no close substitutes. If a monopolist raises its prices, some consumers may choose not to purchase its product - but they will then need to buy a completely different product. However, when a monopolistic competitor raises its prices, some consumers will choose not to purchase the product at all, but others will choose to buy a similar product from another firm. If a monopolistic competitor raises its price, it will not lose as many customers as would a perfectly competitive firm, but it will lose more customers than would a monopoly that raised its prices.

The theoretical problem because of interdependency in the long period firm demand curve under monopolistic competition can be solved by using a concept .i .e. zero problem solution. The existence of economic profits in a monopolistic competitive industry will induce entry in the long run. The long-run equilibrium solution in monopolistic competition always produces zero economic profits. The zero profit solution occurs at the point where the downward sloping demand curve is tangent to the average total cost curve, and thus the average total cost curve is itself downward sloping.

A firm that operates to the left of the lowest point on its average total cost curve has excess capacity. Because monopolistic competitive firms charge prices that exceed marginal costs, monopolistic competition is inefficient. The marginal benefit consumers receive from an additional unit of the good is given by its price Since the benefit of an additional unit of output is greater than the marginal cost, consumers would be better off if output were expanded. Furthermore, an expansion of output would reduce the average total cost.