Question

If the firms in a monopolistically competitive market are earning economic profits or losses in the short run, would you expect them to continue doing so in the long run? Why?

a. Yes, because there are no barriers to entry in the long run
b. No, because firms will exit or enter until economic profits are zero
c. Yes, because firms have market power in the long run
d. No, because firms in monopolistic competition always make losses

Answer 1

Firms in monopolistically competitive markets will not maintain economic profits or losses in the long run due to entry and exit dynamics, which ensure that economic profits and losses tend towards zero (option b).

Step-by-step explanation:

If the firms in a monopolistically competitive market are earning economic profits or losses in the short run, we would not expect them to continue doing so in the long run. This is primarily due to the characteristics of monopolistic competition, namely the lack of barriers to entry and the freedom of exit from the market. In the face of economic profits, new firms will be attracted to the industry, entering the market until the economic profits have been competed away and are driven down to zero. Conversely, if existing firms are incurring economic losses, some will exit the industry, which will reduce the losses for the remaining firms until they reach a break-even point where economic losses are brought up to zero.

In the long run, therefore, the process of entry and exit ensures that firms in a monopolistically competitive market will tend towards earning zero economic profit. This outcome is different from perfect competition, as monopolistic competition offers product differentiation and variety but may not achieve perfect productively efficient or allocatively efficient outcomes.