THE LONG RUN EQUILIBRIUM

The situations depicted in Figure f do not last long. When firms are making profits, as in panel (a), new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products fall, these firms experience declining profit. Conversely, when firms are ‘making losses, as in panel (b), firms in the market have an incentive to exit.

As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. In other words, losses encourage·exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms’ products rises, these firms experience rising profit (that is, declining losses). This process of entry and exit continues until the firms in the market are mwg exactly zero economic profit. Figure 2 depicts the long-run equilibrium. Once the market reaches this equilibrium, new firms have no incentive to enter, and existing firms have no incentive to exit.

Figure 2 A Monopolistic Competitor in the Long Run

Notice that· the demand curve in this figure just barely touches the average-total-cost curve. Mathematically, we say the two curves are tangent to each other. These two curves must be tangent once entry and exit have driven profit to zero. Because profit per unit sold is the difference between price (found on the demand curve) and average total cost, the maximum profit is zero only if these two curve touch each other without crossing.

• As in a monopoly market, price exceeds marginal cost. This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward-sloping demand curve makes marginal revenue less than the price.

• As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero.

The second characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close substitutes, it can earn positive economic profit, even in the long run. By contrast, because there is free entry into a mono.

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