Question

How does a monopolistic competition firm reach equilibrium in the long run? Explain with the help of a diagram.

Answer 1

In the long run under monopolistic competition, firms reach equilibrium when they earn normal profit. Initially, if existing firms earn supernormal profits, new firms are attracted to enter the market due to freedom of entry and exit. As new firms enter, the demand for each individual firm's product decreases because customers now have more substitutes to choose from. This causes the Average Revenue (AR) curve to shift leftward until it becomes tangent to the Long Run Average Cost (LAC) curve.

At the point of tangency:

• The firm earns normal profit (AR = AC).
• The firm’s profit is maximised where Marginal Cost (MC) = Marginal Revenue (MR).
• The firm is in equilibrium and has no incentive to either enter or exit the market.

This situation leads to excess capacity, as the firm does not produce at the minimum point of the AC curve.