Monopolistic competition is characterized by a large number of firms producing goods or services that are differentiated from one another. 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.

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 owing to its differentiated product. The firm can raise its price without losing all its sales to rival firms. To use the graph, use the mouse to drag the demand curve; clicking on the Adjust button will illustrate how the market and firm respond to restore long-run equilibrium. The Show Profit button will illustrate any short-run profits available to the firm.

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 profits increase in the short run?
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3. In response to an increase in industry demand, how will this firm respond in the long run? Will its profits increase 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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