a) Explain why a firm in monopolistic competition will make only normal profit in

the long run.

Monopolistic competition is a market structure that has both the characteristics of
Perfect Competition and Monopoly. In monopolistic competition, there is a large
number of firms like Perfect Competition which ensures that each of the firms has
only a small share of the market in relation to the total industry, meaning that each
firm acts independently of the others. Another similarity to Perfect Competition is that
there are no significant barriers to entry or exit, meaning that new entrants can enter
or leave the industry when they want to. However, unlike Perfect Competition where
firms in each industry produce identical products, in MPC each firm produces a
product that is differentiated, meaning that they are different from others. Product
differentiation can be achieved by physical differences, quality differences, location,
product image and etc.

The assumption of free entry and exit of firms in the industry is very important in
determining the long-run equilibrium of the firm, which is indeed similar to perfect
competition. In monopolistic competition, in the long-run, profit making industries
attract new entrants; loss making firms shut down and exit the industry. This process
of entry and exit of the firms ensures that economic profits or losses are zero,
meaning that all firms earn normal profit. Figure 1 (a) shows the short run equilibrium
of a firm making supernormal profit. As firms can adjust both their fixed and variable
inputs in the long run, this allows new entrants into the industry drawn by the
economic profits that were being made in the short run. As new firms enter, they
attract customers away from the existing firms. This affects the demand curve as it
now shifts to the left due to the lower demand. Firms will continue to enter the market
as long as there are still economic profits, correspondly, the demand curve facing
them will continue shifting until it reaches the point where it is tangent to the ATC
curve. Finally, at this point the firms in the industry earn normal profits and due to
that, entry and exit of firms into the industry stops as there is no longer any incentive
like economic profit. Figure 2 demonstrates the long-run equilibrium of the
monopolistic firms where P=ATC; therefore the economic profit is zero meaning that
each firm is earning normal profit.

Figure 1 (C) shows the short run equilibrium of a loss making firm. As there are no
fixed inputs in the long run, the presence of losses will make some firms shut down
completely and leave the industry in the long run. This results in the customer
switching their purchases to the remaining firms in the industry which now experience
an increase in demand for their product. This appears as a rightward shift of the
demand curve. This process continues until losses completely disappear and firms
are earning normal profit. Like mentioned before, this occurs when the demand is
tangent to the ATC curve where P=ATC and economic profit is zero.
Figure 2 demonstrates the long-run equilibrium of the monopolistic firms where
P=ATC; therefore the economic profit is zero meaning that each firm is earning
normal profit.
 b) Evaluate the view that monopolistic competition is a more efficient market
structure than monopoly.
(Monopolistic competition has been defined in part A)
A monopoly consists of a single or dominant seller producing a good or service for the entire
industry. There are no close substitutes that exist for the product produced by the monopolist
as customers would switch to the substitutes if they were available. The monopolists owe its
dominance in the market to the barriers of entry and exit that exist to prevent other firms from
entering or leaving the industry.

There are many similarities and differences between the two market structures. In
monopolistic competition, there is a large number of firms like perfect competition, however
in a monopoly there is only a single or dominant firm. In monopolistic competition firms are
usually small, whereas in a monopoly the fact there is a single or dominant firm suggests a
very large size. Another difference between them is in terms of the barriers of entry and exit,
which exists in a monopoly but not in monopolistic competition where firms can enter or
leave the industry as their desire. In the long run, a firm under monopolistic competition
earns normal profit as firms can enter or exit the industry based on incentives, however, in a
monopoly, firms can earn economic (supernormal) profits due to the high barriers to entry
that prevent new entrants from entering the industry which is why the profit is solely enjoyed
by themselves. Both a monopoly and firms in monopolistic competition have market power,
and therefore have a downward sloping demand curve. However, in comparison, a
monopoly is likely to have more market power because there are no substitutes for the good
produced by the monopolist. Another key difference between monopoly and monopolistic
competition is the extent to which economies of scale can be exploited. Firms under
monopolistic competition can exploit small economies of scale, however, the potential for
this is much greater in a monopoly due to its massive size, could perhaps be a benefit for
consumers as a lower price is likely to be charged. Lastly, the economic profits that a
monopoly can earn over the long run allows them to extensively invest in research and
development, which is something monopolistically competitive firms cannot do due to the
normal profits they earn in the long run.

In order to evaluate the view that monopolistic competition is a more efficient market
structure than monopoly, it is going to easier to first compare a monopoly to perfect
competition, which is the only market structure out of the three (monopoly, perfect
competition and monopolistic competition) that achieves allocative efficiency.

A comparison of monopoly with perfect competition at the industry level reveals that price is
higher and quantity of output is produced is lower in monopoly. Figure 3, shows the long run
equilibrium position of a perfectly competitive industry and a monopoly. Since Qm<Qpc, the
industry under monopoly produces a smaller quantity of output than the industry under
perfect competition. And since Pm>Ppc, the monopolist sells output at a higher price.
The higher price and lower output of the monopolist have important implications for
consumer and producer surplus. Whereas the perfectly competitive industry achieves
allocative efficiency shown by MB = MC and maximum social surplus, monopoly does not.
This can be seen in Figure 4, which is the same as Figure 3, only consumer and producer
surplus have been drawn in. In part (a), area A represents consumer surplus, while area B is
producer surplus, with A + B showing maximum social surplus. Part (b) shows the
inefciencies that result in monopoly than the perfectly competitive industry. Area C,
consumer surplus in a monopoly is smaller than area A in perfect competition. A portion of
area A was converted into producer surplus because of the higher monopoly price and
another part of triangle A was lost as triangle E because of the lower quantity produced in a
monopoly. Area E represents a welfare (deadweight) loss. Area D, which is producer surplus
in a monopoly has increased by taking away a portion of consumer surplus (Area C). It has
also decreased by losing area F, which is considered as welfare loss. The presence of
welfare loss means that MC and MB are longer equal, and that there is allocative
inefficiency. Now, relating this to monopolistic competition, allocative efficiency is also not
achieved in the market structure, however as monopolistically competitive firms have less
market power, they are likely to set lower prices and produce more than a monopoly, which
signifies that there is smaller deadweight loss in monopolistic competition. Monopolistically
competitive firms will also operate closer to minimum ATC.