How the market moves from the short run to the long run

Overview

How entry competes supernormal profit away, how exit removes losses, and where the market settles once both have run their course.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain the process by which supernormal profit is competed away in a monopolistically competitive market.

   Model answer

   The profit is visible and entry is unobstructed, so new firms set up offering similar products. Each entrant takes a share of the customers, so every existing firm's average revenue curve shifts to the left: at any price it now sells less. The extra substitutes also make each firm's demand more elastic, so the curve becomes flatter, since buyers now have more places to go if the price rises. Marginal revenue shifts left with average revenue, so each firm's profit-maximising output falls and the price it can charge falls with it. Entry continues while any firm can price above average total cost, and stops when average revenue is merely tangent to average total cost and only normal profit remains.

2. 2

   Explain the process by which losses are eliminated in a monopolistically competitive market.

   Model answer

   Firms making losses leave the trade once they can escape their fixed costs. Their customers are redistributed among the survivors, so each remaining firm's average revenue curve shifts to the right: at any price it now sells more. With fewer substitutes available the curve also becomes steeper and less elastic, since buyers have fewer alternatives. Marginal revenue shifts right with it, so each survivor's profit-maximising output and price both rise and the gap between price and average total cost narrows. Exit continues while losses remain and stops when average revenue has risen just far enough to be tangent to average total cost.

3. 3

   A firm has costs TC = 30 + 10Q + Q² and its demand shifts from P = 25 − 0.2Q to P = 22 − 0.2Q as new firms enter. Show what happens to its output, price and profit.

   Model answer

   With demand P = 25 − 0.2Q, marginal revenue of 25 − 0.4Q equals marginal cost of 10 + 2Q at Q = 6.25 units, giving a price of £23.75, average cost of £21.05 and supernormal profit of £16.88. After entry, with demand P = 22 − 0.2Q, marginal revenue of 22 − 0.4Q equals marginal cost at Q = 5 units, giving a price of £21. Average total cost at 5 units is 105 ÷ 5 = £21, so total revenue of £105 exactly equals total cost of £105 and profit is zero. Entry has therefore cut the firm's output by 1.25 units, its price by £2.75 and its supernormal profit to nothing.

4. 4

   A firm has costs TC = 30 + 10Q + Q² and its demand shifts from P = 19 − 0.2Q to P = 22 − 0.2Q as rival firms leave the trade. Show what happens to its output, price and profit.

   Model answer

   With demand P = 19 − 0.2Q, marginal revenue of 19 − 0.4Q equals marginal cost of 10 + 2Q at Q = 3.75 units, giving a price of £18.25 against average total cost of £21.75, so the firm loses £13.13. As rivals exit, its customers are redistributed and demand rises to P = 22 − 0.2Q. Marginal revenue now equals marginal cost at Q = 5 units, the price rises to £21, and average total cost falls to £21 because the larger output spreads the £30 of fixed costs more thinly. Revenue of £105 matches cost of £105, so the loss is eliminated and the survivor earns normal profit.

5. 5

   Describe the diagram showing a monopolistically competitive market moving from short-run supernormal profit to long-run equilibrium.

   Model answer

   Use one panel with quantity on the horizontal axis and price, cost and revenue in pounds on the vertical, and draw the position twice. Initially a downward-sloping average revenue curve lies above the average total cost curve over a range of outputs, its marginal revenue curve is cut from below by marginal cost, and the price read up to average revenue exceeds average cost, so a profit rectangle can be shaded between them. Then shift the average revenue curve to the left and make it flatter, and shift marginal revenue left with it. The new marginal revenue cuts marginal cost at a smaller output, and the new average revenue curve just touches the average total cost curve at exactly that output. The profit rectangle has shrunk to nothing, and the cost curves have not moved at all.

6. 6

   When new firms enter a monopolistically competitive market, what shifts and what stays still?

   Model answer

   The individual firm's average revenue curve shifts to the left and becomes flatter, and its marginal revenue curve shifts with it, because customers and their loyalty are being drawn away by the entrants. The firm's own cost curves do not move: entry changes nothing about its technology, its inputs or its scale of plant, so marginal cost and average total cost stay exactly where they were. Only if the entrants bid up the price of an input, or provoke extra advertising spending, would the cost curves shift as well, and that would be a separate effect.

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