Question

Why does a monopolistically competitive firm make zero profit in the long-run? Explain graphically and verbally.

Answer 1

The firms demand curve is flatter than the total market demand curve in monopolistic competition because it is easier for customer to switch to another firm’s highly substitutable product instead of switching consumption to different product. The product made by the market has its substitutes however the product made by firm’s within the market does not have substitutes. The profit opportunities will attract new entrants and as there are no barriers to entry exist in a monopolistically competitive market thus new firms can easily enter the market in the long-run. As a result the firms enter the incumbent firm’s demand and marginal revenue curves shift inward thus declining the profit-maximizing quantity. In the long run eventually the profits fall to zero thus there would be not be any incentive for more firms to enter and the demand curve in the long run shifts to left

The firm's long-run equilibrium situation under monopolistically competitive is illustrated in the enclosed graph. When new firms enters the market it causes an increase in the supply of differentiated products, thus would lead to shift the market demand curve towards the left. With more new entrants the demand curve of a firm will continue shifting to the left until at the profit maximizing level of output it becomes tangent to the average total cost curve as depicted in the graph. The economic profits of the firms are zero at this point, and there is no incentive for new firms to enter the market. Therefore the competition brought due to new entrants will cause the firms under monopolistically competitive market to only earn normal profits, as alike the perfectly competitive firm