Graphing Exercise: Monopolistic Competition

Monopolistic competition is characterized by a large number of firms producing goods or services that are differentiated from one another.  That is, the firms produce close, but not perfect, substitutes.  Entry of new firms into the industry is relatively unrestricted.  As a result, the typical firm will earn no economic profit in the long run.

Exploration: What are the characteristics of short-run and long-run equilibrium in a monopolistically competitive industry?


The graph illustrates the demand and cost conditions for a typical firm in a monopolistically competitive industry.  Its demand curve is downward sloping to reflect the monopoly power that arises from its product differentiation.  The firm can raise its price without losing all its sales to rival firms.  To use the graph, drag the demand curve with the mouse; the Show Profit/Loss button will illustrate any short-run profit available to the firm.  Clicking on the Market Adjustment button will illustrate how the market and firm respond to restore long-run equilibrium.

  1. Given the initial demand and cost conditions, what output level and price will maximize the firm’s profit?  What profit level can the firm attain?
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  2. Suppose demand for the products made by this industry increases.  How will this firm respond in the short run?  Will its profit increase in the short run?
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  3. In response to an increase in industry demand and the resulting change in industry profits, what will happen to the number of firms in the industry?  What impact will this have on this representative firm’s demand and marginal revenue curves?  How will this firm respond to these changes?  Will it make a positive economic profit in the long run?
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  4. Experiment on your own.  How would the firm and industry respond to a decline in demand in both the short and long run?  What generalization can you make?
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