Monopolistic Competition

Question 1

key features of monopolistic competition?

Answer 1

There are many small buyers and sellers.
Low barriers to entry or exit which means firms can easily enter and exit the market.
Differentiated goods. All goods must be similar but slightly different.

Question 2

Because Gaurav is making supernormal profit, new entrants will be incentivised to enter the industry.

These new entrants will steal Gaurav’s customers.

How will this affect Gaurav?

Answer 2

Garuav’s AR and MR decrease

Question 3

Explain what happens as a monopolistically competitive market moves to its long run equilibrium. (4 marks)

Answer 3

In the short run, if a monopolistically competitive firm is making supernormal profit, it will incentivise new firms to enter the market.

There are low barriers to entry, so new firms will enter the market, stealing customers from existing (or incumbent) firms.

This will decrease their demand (or AR), shifting AR and MR down, until AR just touches the firm’s AC curve - so only normal profit will be left and all the supernormal profit is gone,.

Potential suppliers outside the market will no longer enter the market because they can no longer make supernormal profit, so we have reached the long run equilibrium.