Question

Problem 3:

a. How does monopolistic competition differ from perfect competition?

b. If monopolistically competitive firms are making economic profits in the short run? What happens in the long run?

Answer 1

A)The difference arises on many accounts the primary difference being the type of good produced. Perfectly competitive market produced identical goods while monopolistically competitive markets produce differentiated good, differentiation being done in terms of packaging designing and sometimes quality. Then there are the number of firms which is very high in perfectly competitive market but quite a few in monopolistically competitive market.

Then there is a ability to charge a price according to the acquired market power. Firms under perfectly competitive market charge a same price which is determined by the market outside their reach. In monopolistically competitive markets, firms can decide their own prices depending upon their demand function, which is downward sloping. Demand function for perfectly competitive firm is in contrast, horizontal reflecting their inability to influence the price. Then there is a difference in the production capacity. A perfectly competitive firm in the long run always produces at its maximum capacity that minimises the cost. Firms in monopolistically competitive market in the long run, produce at an excess capacity.

B) in the long run there will be more number of such firms in the market, attracted by the short run profits. This will decrease the the demand faced by respective firms show the demand function and the marginal revenue function both start shifting to the left for each firm. This reduces the price and the profit till all the economic profit is vanished. In the long run no firm earns economic profit.