Check Your Understanding

1. Question

   Suppose a monopolistically competitive industry composed of firms with U-shaped average total cost curves is in long-run equilibrium. For each of the following changes, explain how the industry is affected in the short run and how it adjusts to a new long-run equilibrium.

   1. a technological change that increases fixed cost for every firm in the industry

      An increase in fixed cost shifts the average total cost curve upward. In the short run, firms incur losses because price is below average total cost. In the long run, some firms will exit the industry, resulting in a rightward shift of the demand curves for those firms that remain, since each firm now serves a larger share of the market. Long-run equilibrium is reestablished when the demand curve for each remaining firm has shifted rightward to the point where it is tangent to the firm’s new, higher average total cost curve. At this point, each firm’s price just equals its average total cost, and each firm makes zero profit.

   2. a technological change that decreases marginal cost for every firm in the industry

      A decrease in marginal cost shifts the average total cost curve and the marginal cost curve downward. In the short run, firms earn positive economic profit. In the long run, new entrants are attracted to the industry by the profit. This results in a leftward shift of each existing firm’s demand curve because each firm now has a smaller share of the market. Long-run equilibrium is reestablished when each firm’s demand curve has shifted leftward to the point where it is tangent to the new, lower average total cost curve. At this point, each firm’s price just equals average total cost, and each firm makes zero profit.

2. Question

   Why is it impossible for firms in a monopolistically competitive industry to join together to form a monopoly that is capable of maintaining positive economic profit in the long run?

   If all the existing firms in the industry joined together to create a monopoly, they could achieve positive economic profit in the short run. But this would induce new firms to create new, differentiated products and then enter the industry and capture some of the profit. So, in the long run, thanks to the lack of barriers to entry, it would be impossible to maintain such a monopoly.

3. Question

   Indicate whether the following statements are true or false, and explain your answers.

   1. Like a firm in a perfectly competitive industry, a firm in a monopolistically competitive industry is willing to sell a good at any price that equals or exceeds marginal cost.

      False. As illustrated in panel (b) of Figure 67.4, a monopolistically competitive firm sells its output at a price that exceeds marginal cost—unlike a perfectly competitive firm, which sells at a price equal to marginal cost. Not only does a monopolistically competitive firm maximize profit by charging more than marginal cost, but in long-run equilibrium, a price equal to marginal cost would be below average total cost and cause the firm to incur a loss.

   2. Suppose there is a monopolistically competitive industry in long-run equilibrium that possesses excess capacity. All the firms in the industry would be better off if they merged into a single firm and produced a single product, but whether consumers would be made better off by this is ambiguous.

      True. Firms in a monopolistically competitive industry could achieve higher profit (monopoly profit) if they all joined together as a single firm with a single product. Because each of the smaller firms possesses excess capacity, a single firm producing a larger quantity would have a lower average total cost. The effect on consumers, however, is ambiguous. They would experience less choice. But if consolidation substantially reduced industrywide average total cost and increased industrywide output, consumers could experience lower prices with the monopoly.

   3. Fads and fashions are more likely to arise in industries characterized by monopolistic competition or oligopoly than in those characterized by perfect competition or monopoly.

      True. Fads and fashions are promulgated by advertising and a desire for product differentiation, which are common in oligopolies and monopolistically competitive industries, but not in monopolies or perfectly competitive industries.