Question

1. Why does a firm in the monopolistic competition face a downward-sloping demand curve?

2. How is it possible that monopolistically competitive firms have market power and yet cannot earn a long-run profit?

Please explain both in more detail.

Answer 1

Q1) A monopolistic competitive firm, unlike perfectly competitive firms, enjoys some market power. This is because, under monopolistic competition, firms sell products that are slightly differentiated, and even very similar products can become differentiated due to branding. Thus, the firms can raise the market price and they will still not lose all the customers as all the customers will not switch to products of competitors as the customers do not see the products as perfect substitutes.

Q2) The long-run profits are 0 because of the freedom fo entry of firms in the long run. More and more firms are attracted to the profitable market and thus there is an increase in the supply of differentiated products. This causes the demand for firms to shift to the left. This will lead to a point where the average total cost curve is tangent to the demand curve and the profits would be 0 and no more firms will enter the market.