Question

Explain the equilibrium of a firm under monopolistic competition.

Answer 1

Under monopolistic competition, a firm reaches equilibrium by producing the level of output where Marginal Revenue (MR) equals Marginal Cost (MC). This stage is the point where the firm maximises its profit or minimises its loss. The firm faces a downward-sloping demand curve due to product differentiation, giving it some control over price.

1. Short-Run Equilibrium: In the short run, a firm can earn:
   1. Supernormal profits if Average Revenue (AR) > Average Cost (AC) at equilibrium output
   2. Normal profits if AR = AC
   3. Losses if AR < AC
   4. The firm sets output where MR = MC and determines the price from the AR (demand) curve.
2. Long-Run Equilibrium: In the long run, if firms are earning supernormal profits, new firms enter the market. This reduces the demand for each existing firm’s product. As a result, the AR curve shifts leftward until it becomes tangent to the AC curve, and the firm earns only normal profits. The firm continues to produce where MR = MC, but now AR = AC, indicating long-run equilibrium.

Thus, the firm is in equilibrium when it has no tendency to change its price or output and earns normal profits in the long run.