A firm in a monopolistically competitive market can earn both short-run and long-run profits.
A. True
B. False
The correct answer and explanation is:
The correct answer is B. False.
In a monopolistically competitive market, firms can earn profits in the short run but cannot earn long-run profits. Here’s why:
- Short-Run Profits: In the short run, a monopolistically competitive firm may experience profits because it can differentiate its products from competitors. This differentiation allows the firm to have some market power and charge a price higher than marginal cost. In this case, if the firm’s average total cost is below the price at which it sells its product, it will earn positive economic profits.
- Long-Run Adjustments: However, in the long run, these profits will attract new firms to enter the market because there are no significant barriers to entry in monopolistic competition. As new firms enter the market, they introduce similar products, increasing the supply of goods available to consumers. This leads to a reduction in the demand for each individual firm’s product. As competition increases, the price that firms can charge falls, and their economic profits diminish.
- Zero Economic Profits in the Long Run: In the long run, the process of entry and exit of firms continues until firms are making zero economic profits. At this point, firms are operating at a point where their price equals their average total cost, and no firm has an incentive to enter or exit the market. The firm will still make a normal profit (covering all its costs, including opportunity costs), but it will not make an economic profit.
Therefore, in the long run, the monopolistically competitive firm is left with no economic profit due to the competition introduced by new firms entering the market. The firm will produce where price equals average total cost, leading to zero economic profit.