Monopolistic Competition

Question 1

What are the assumptions for monopolistic competition?

Answer 1

-All firms seek to maximise profit (MR=MC)
-each firm produces slightly differentiated products with slight product variation
-the wider industry has a large number of firms
-Each individual firm is small relative to the size of the wider industry
-firms act independently from one another and have some control over the price of their own product
-free entry and exit from the industry for firms
-very good knowledge and infromation for producers and consumers

Question 2

What is the diagram for monopolistic competition in the long run ?

Answer 2

Question 3

Why is a normal profit the only possible outcome for monopolistic competition in the long run ?

Answer 3

-if firms are earning supernormal profits in the short run, there will be an incentive for new firms to enter the industry (free entry and exit). In the long run supernormal profits would be eroded because new firms entering the industry increase the number and availability of alternative products.
the increase in the market supply competes away any supernormal profits. The demand for the product sold for each firm will fall (due to an increase number of substitutes) and the demand curve for the individual firms’ will shift the to the left. Demand for the firms may also become more price elastic as more substitutes become available.