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Difficulty: HardMonopolistic Competition: Features, Product Differentiation, and Equilibrium

A firm operating in a monopolistically competitive market currently produces 1010 units of output where its marginal revenue (MRMR) equals marginal cost (MCMC). At this output, the product sells at a market price (PP) of $40\$40, while the average total cost (ATCATC) is $30\$30. Based on economic theory, which of the following long-run market adjustments will occur, and what will be the resulting economic profit position of this firm?

  1. New firms will enter the market, causing the demand curve for this firm's product to shift to the left until price equals average total cost and economic profit is reduced to zero.Answer
  2. B
    Existing firms will expand output to reach the minimum point of their average total cost curve, resulting in long-run productive efficiency and zero economic profit.
  3. C
    New firms will enter the market, forcing the firm to cut prices until marginal revenue equals average total cost, resulting in short-term economic losses.
  4. D
    High entry barriers will block potential competitors, allowing the firm to maintain its price of $40\$40 and preserve economic profit of $100\$100 indefinitely.

Answer

New firms will enter the market, causing the demand curve for this firm's product to shift to the left until price equals average total cost and economic profit is reduced to zero.
In the short run, the firm earns positive economic profit because price ($40\$40) exceeds average total cost ($30\$30). Due to freedom of entry in monopolistically competitive markets, these profits attract new sellers offering competing differentiated products. Entry decreases demand for the incumbent firm's specific brand, shifting its demand curve to the left until price equals average total cost at the output where marginal revenue equals marginal cost, leaving the firm with zero economic profit in the long run.

Step-by-Step Solution

1
Determine short-run profit status
Economic profit per unit = P−ATC=$40−$30=$10P - ATC = \$40 - \$30 = \$10. Total profit = $10×10=$100\$10 \times 10 = \$100.
Because price exceeds average total cost at the profit-maximizing output (MR=MCMR = MC), the firm is making positive economic profit (supernormal profit) in the short run.
2
Analyze structural features and market dynamics
Free entry allows new rival firms selling differentiated substitute products to enter the market.
Monopolistic competition has freedom of entry and exit, so short-run economic profits attract new market entrants.
3
Evaluate long-run adjustment mechanism
The demand (average revenue) curve facing the incumbent firm shifts to the left and becomes more elastic.
As buyers spread their purchases across a wider variety of substitute brands, individual firm demand decreases until the demand curve becomes tangent to the average total cost curve (P=ATCP = ATC), eliminating economic profit.

Key Concept

Short-run to long-run adjustment in monopolistic competition
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Topics

Monopolistic Competition: Features, Product Differentiation, and Equilibrium

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