Question

How is price determined under monopolistic competition?

Answer 1

• Each firm determines its price where its marginal cost (MC) equals marginal revenue (MR), similar to monopoly pricing because the firm faces a downward-sloping demand curve.
• The firm has some discretion over price because of product differentiation but has limited market power due to the existence of close substitutes.
• The demand curve faced by the firm is relatively elastic because if it raises the price too much, buyers can switch to close substitutes.
• In the short run, a firm can earn supernormal profits or incur losses depending on market conditions.
• In the long run, due to free entry and exit, firms earn normal profits, as entry of new firms shifts the demand curve faced by each existing firm until economic profits are zero.