Theory question 108
Market Structures(a) State two characteristics of monopolistic competition.
(b) With the aid of diagram(s), explain why a firm in monopolistic competition is unable to earn abnormal profits in the long run.
(c) Differentiate between natural monopoly and legal monopoly.
Show the model answer
(a) Any two: many sellers; differentiated products (brands); free entry and exit; some control over price (downward-sloping demand); heavy advertising.
(b) In the short run a firm may earn abnormal profit (AR above AC at the output where MC = MR). Because entry is free, new firms producing close substitutes enter; each firm's demand (AR) curve shifts left and becomes more elastic until it is tangent to the AC curve. At the long-run equilibrium MC = MR and AR = AC, so only normal profit is earned. Diagram: AR tangent to the falling part of AC above the output where MC = MR.
(c) Natural monopoly arises from natural factors such as sole control of a natural resource or economies of scale so large that one firm serves the market most cheaply. Legal monopoly is created by law, e.g. patents, copyrights, licences or statutory grants to one firm.
Free entry removes abnormal profit in the long run.