Question

Increasing Returns and Monopolistic Competition

     A. Model of Monopolistic Competiton

         - ATC and MC curves

         - Entry, exit and long-run equilibrium

     B. Effect of trade in the short-run

     C. Effect of trade in the long-run

         - Effect on total number of firms

         - Effect on ATC

Answer 1

Increasing Returns and Monopolistic Competition

Monopolistic competition is characterized by the large number of buyers and sellers. Sellers have very close substitute products. There is high selling cost in the monopolistic competition.

     A. Model of Monopolistic Competiton

         - ATC and MC curves : Increasing returns implies that increase in variable input causes disproportionate impact on total output. Hence, here both ATC and MC shape downwards. Increasing returns keep shapes of ATC and MC downward.

         - Entry, exit and long-run equilibrium: Increasing returns increases profits of firms in industry. Thus, more firms are likely to enter the entry to reap profits. Overall output rises and prices fall. Profits get reduced in long run owing to influx of new firms.

     B. Effect of trade in the short-run

Firms get profits in short run due to increasing returns.

     C. Effect of trade in the long-run

         - Effect on total number of firms : total number of firms increases due to profits and increasing returns.

         - Effect on ATC : Gradually increasing returns wither away when more firms enter the market. Hence, ATC begins to rise.