Question

Monopolistically competitive firms compete only on price, earn excess economic profits in the LR and lead to wastage of scarce resources through excess capacity. In addition, the business stealing effect imposes a large cost on society. Do you agree? Carefully analyse each part of this statement briefly.

Answer 1

In a monpolistically competitive market structure, each firms sell differentiated goods. Therefore, each firm will also have different prices for their products. Now, since a monopolistically competitive fimrs compete only on price, economic profits will be alluring to the new firms who would want to enter the market in the long run. Since there is no barrier to entry, many new firms will try to set their foot in the market and this will give rise to the supply of differentiated goods in the economy. This will lead to inefficiency in the market structure as the firms will fail to attain highest efficient level of output and in turn will give rise to excess capacity problem i.e., even if a firm can easily produce more goods with the available resources; it is not able to do so. This will lead to wastage of limited resources.

In addition to that, the business stealing effect imposes a large cost on society. This negative externality is caused owing to the fact that as many new firms enter the market, the remaining firms have a high chance of losing its faithful customers.