a) Explain the difference between short-run and long-run equilibrium in monopolistic competition.
7th November 2007
An industry in monopolistic competition is one made up of a large number of small firms who produce goods which are only slightly different from that of all other sellers. It is similar to perfect competition with freedom of entry and exit for firms and any supernormal profits earned in the short-run will be competed away in the long-run as new firms enter the industry and compete away the profits.
Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit.
Perfect competition is considered as the ideal or the standard against which everything is judged. Perfect competition is characterised as having:
- Many buyers and sellers. Nobody has power over the market.
- Perfect knowledge by all parties. Customers are aware of all the products on offer and their prices.
- Firms can sell as much as they want, but only at the price ruling. Thus sellers have no control over market price. They are price takers, not price makers.
- All firms produce the same product, and all products are perfect substitutes for each other, i.e. goods produced are homogenous.
- There is no advertising.
- There is freedom of entry and exit from the market. Sunk costs are few, if any. Firms can, and will come and go as they wish.
- Companies in perfect competition in the long-run are both productively and allocatively efficient.
In perfect competition, the market is the sum of all of the individual firms. The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the cost model (standard average and marginal cost curves). The firm as a price taker simply ‘takes’ and charges the market price (P* in Figure 1 below). This price represents their average and marginal revenue curve. Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.
Firms in equilibrium in perfect competition will make just normal profit. This level of profit is just enough to keep them in the industry and since profits are adequate they have no incentive to leave.
Normal profit is the level of profit that is required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits.
Any profit above normal profit is a ‘bonus’ for the firms, as it is more than they need to keep them in the industry. We call this supernormal (or abnormal) profit. However, this supernormal profit will be a signal to other firms and will attract more firms into the industry. If firms are making consistently below normal profits then they will choose to leave the industry.