Question

Explain the equilibrium of an industry under monopolistic competition.

Answer 1

Under monopolistic competition, the industry reaches equilibrium in the long run when the number of firms becomes stable, and no new firm has an incentive to enter or exit the market. This happens when all firms in the industry are earning normal profits.

In the short run, some firms may earn supernormal profits, which attract new entrants. As new firms enter, the demand for each existing firm’s product decreases due to increased competition and availability of close substitutes.

In the long run, the entry of new firms continues until supernormal profits are eliminated. At this point, all firms in the industry:

• Earn normal profit (i.e., Average Revenue = Average Cost)
• Produce at a point where Marginal Cost = Marginal Revenue
• Face a downward-sloping demand curve due to product differentiation
• Operate with excess capacity (i.e., not at the minimum point of AC curve)

Thus, the industry is in equilibrium when firms have no tendency to enter or exit, and all firms are making normal profits under conditions of product differentiation.