10.6: Long-run Equilibrium under Monopolistic Competition

In the long run, the equilibrium under monopolistic competition is characterized by firms making zero economic profit, also known as normal profit. This outcome results from the freedom of entry and exit in the market. When firms in the market make supernormal profits in the short run, the attractive returns draw new firms into the industry. These new entrants increase the competition, diluting the demand for each existing firm's differentiated product, causing their demand curves to shift leftward. The process continues until each firm's demand curve is tangent to its average total cost (ATC) curve at the output level, where marginal revenue (MR) equals marginal cost (MC), ensuring no economic profits are made.

At this tangent point, firms are not operating at the minimum point of their ATC curve, which would represent the most efficient production level and lowest cost. This situation is known as excess capacity. Consequently, the price set by firms exceeds marginal cost, indicating that goods are produced at a higher cost than in perfectly competitive markets. This results in allocative inefficiency, as resources are not optimally allocated from society's perspective. If firms start incurring losses, the opposite process ensues: firms exit the market, reducing competition and allowing remaining firms to increase their market share.

This dynamic equilibrium is reached only when there is no further entry or exit of firms, indicating a stable market condition.

It's important to note that while firms earn zero economic profit in the long run, they still earn accounting profit. The persistence of product differentiation and advertising in this market structure reflects ongoing non-price competition among firms to maintain their market share and potentially earn short-run profits. This model helps explain the behavior of many retail and service industries, where we observe continuous product differentiation efforts and frequent entry and exit of firms.

In monopolistic competition, firms reach an equilibrium where marginal revenue equals marginal cost. Here, firms have the freedom of entry and exit.

In the long run, new firms enter the market, attracted by the short-run profits. This increases competition, leading to a decrease in demand for existing firm's products. The demand curve shifts leftward until tangent with the average ATC curve. At this point, economic profits become zero, and long-run equilibrium is achieved.

The zero economic profit implies that the firms cover all their costs, including a normal return on investment.

This equilibrium point is to the left of the minimum of the ATC, indicating goods are not produced at the lowest cost. Here, the price exceeds the marginal cost.

Conversely, if firms incur losses, they will exit, reducing supply and pushing prices until the remaining firms break even.

Long-run equilibrium is achieved when no firms have an incentive to enter or exit, as all firms are earning zero economic profit.

This ensures that while firms cover their costs, they are not producing at maximum efficiency, and the price remains above marginal cost.