Question

The market for laundry detergent is monopolistically competitive. Each firm owns one brand,
and each brand has effectively differentiated itself so that it has some market power (i.e., faces a
downward sloping demand curve). Still, no brand earns economic profits, because entry causes
the demand for each brand to shift in until the seller can just break even. All firms have identical
cost functions, which are U-shaped.
(a) Is this market in long-term or short-term equilibrium? Explain your claim?
Now suppose that the government does a study on detergents and finds out they are all alike. The
public is notified of these findings as a result consumers drop allegiance to any particular brand.
As a result of this event, discuss the long-run effects on the laundry detergent market.
Specifically, answer the following questions:
(b) What will be the effect on the demand curve of firms in this market? Why?
(c) How will this event effect the market price of laundry detergent? Explain.
(d) How will each firm’s supply and sales change? Explain.
(e) Does this event increase or decrease the number of firms in this market? Why?
(f) What will happen to total quantity output in the laundry detergent market? Explain.

Answer 1

a) A monopolistic competitive market is characterized by the presence of large number of sellers for a product which are somewhat differentiated but close substitute to each other. Since the product of one seller is differentiate in some ways from the product of other seller, each seller enjoys some sort of monopoly power over his product. The existence of large number of sellers and close substitutability of product creates competition.

The other feature of monopolistic competition is the freedom of entry and exit. In longrun new firm will enter into the market with the similar product of the existing firms. The entry of new firms into the industry in longrun leads to the increase in supply of the product. This cause the firm’s demand curve to shift to the left. As entry into the market continues, the firm’s demand curve continue to shift to the left until it just tangent to the lowest point of average total cost curve at the profit maximizing level of output. At this level the firm earns zero economic profit or stay at it break-even point. The situation shows that the market is in longrun equilibrium.

b) Each firm in the industry maintains its demand curve due to its customer loyalty which arise out of product differentiation. But the findings of the government that all detergent are alike will reduce the demand for the product of a particular firm. The firm’s demand curve shift to the left.

c) The decreased demand reduce the market price and since all firms in the market were at break-even, the fall in price cause loss to the existing firms.

d) With reduction in sales each firm will reduce the volume of output.

e) The present price cause loss to the prevailing firms and thus some of the firms will quit the industry.

f) As the loss suffering firms leave the industry, the total quantity of output in the industry decrease.