Question

Assume that two firms are operating with identical cost schedules, but one firm is in a perfectly competitive industry,

and the other is in a monopolistically competitive industry.

- a. Using two correctly labeled graphs, show the long run equilibrium price and output levels for each of these two firms.

- b. Compare the long run equilibrium price and output levels for these two firms.

- c. What level of economic profit will each firm earn in the long run? Why do these results occur?

- d. For each of the two firms at the equilibrium quantity, indicate whether the firm’s demand curve is perfectly elastic, elastic, unit elastic, inelastic, or perfectly inelastic. How can you tell?

Answer 1

Ans a)

b) Monopolistic firm produces lower output at higher price than the perfectly competitive firm. This is due to the product differentiation in monopolistic market which gives the firms some market power over the price of the good while in perfect competition all the firms produce homogeneous goods, so, they are price takers and hence, price the goods at marginal cost unlike monopolistic firms.

c) In long run, both the firms earn normal profit because of free entry and exit of firms in the industry. Both produce the quantity of good that has price equal to the average total cost.

d) Perfectly competitive firm faces a perfectly elastic demand curve as evident from the horizontal demand curve in the figure. This is because of large number of buyers and sellers having complete information and each seller producing homogeneous goods. This makes each firm a price taker who faces a perfectly elastic demand curve.

In monopolistic competition, all the conditions are same as perfect competition but goods produced here are differentiated giving each firm some market power over the price of the good. This makes demand curve faced by the firm relatively less elastic i.e. firms face a downward sloping demand curve.

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