(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 ...

Answer Details

(a) Two characteristics of monopolistic competition

• Many sellers and buyers: there are numerous firms, each small relative to the market, so no single firm can dominate.
• Product differentiation: firms sell similar but not identical products (through branding, packaging, quality or service), which gives each firm a small degree of control over its own price.

(Other acceptable points: freedom of entry and exit in the long run, and heavy reliance on non-price competition such as advertising.)

(b) Why no abnormal profit in the long run

The key reason is freedom of entry into the industry. In the short run a firm can earn abnormal (supernormal) profit where price exceeds average cost. Because there are no barriers to entry, these profits attract new firms into the industry. As new firms enter and offer close substitutes, they take customers away from the existing firm. This causes the existing firm's demand (average revenue) curve to shift to the left and become more elastic.

Entry continues until abnormal profits are competed away. Long-run equilibrium is reached when the firm's average revenue curve is just tangent to its average total cost curve. At that tangency point price equals average cost, so the firm earns only normal profit, while it still produces at the profit-maximising output where marginal revenue equals marginal cost.

On the diagram: the downward-sloping AR curve touches the U-shaped AC curve at exactly one point directly above the output where MR = MC. Here \( P = AC \), so abnormal profit is zero. Any attempt by the firm to raise price loses too many customers to rivals; any tendency toward profit invites fresh entry.

(c) Natural monopoly versus legal monopoly

• Natural monopoly arises because of the technical nature of the industry: very large economies of scale and heavy fixed costs mean that a single firm can supply the whole market at a lower average cost than several firms could. Examples are electricity, water and railway supply.
• Legal monopoly exists because the law grants and protects exclusive rights to one producer, for example through patents, copyrights, or a government franchise or licence. Its power comes from statute, not from cost conditions.