With monopolistic competition, the entry of new firms shifts the demand curve faced by each individual firm down to the point where price equals average total cost (p* = ATe*) such that economic profit is zero. Anyone explain this?
Think of it from a competition standpoint. If there is a new industry with one or two firms currently making large profits with low barriers to entry, obviously other companies are going to come in and compete with lower prices and differentiated products. In response to this the other firms will lower their prices as well, thus reducing economic profit. Economic profit will eventually go to zero as more and more firms join the industry.
Agree with dtrynoski. Technically, there are 2 points to be understood: 1. Whenvever, the equilibrium price as determined by firms’s supply curve and demand curve for its product is a) Above the firm’s ATC (Average Total Cost), it will earn Economic Profits (Supernormal Profit) b) Is equal to its ATC, it will earn Normal Profits (No Economic Profits) c) Is less than ATC but above AVC, firm will be taking losses but will continue to operate in short term on the principal of minimization of losses. In this case, firm is able to recover all of its Fixed Costs and part of its Variable Costs. So, it will continue to operate in short run in the hope that prices will increase in future upto or above its ATC. d) Is less than its AFC, firm will seaze operations even in short run, as by running its operations, it is not even able to recover its fixed costs. 2. In monopolistic competition as new firms enter the market, each with thier own differentiated product, they eat into the market share of existing firms. Thus the demand for products from other firms is reduced and the Demand Curve for product of other firms shift to left, thus decreasing their equilibrium price. Hope this helps.
Yes, thanks. What I don’t understand is why the Demand curve shifts down.
That was the second point in my post. 2. In monopolistic competition as new firms enter the market, each with thier own differentiated product, they eat into the market share of existing firms. Thus the demand for products from other firms is reduced and the Demand Curve for product of other firms shift to left, thus decreasing their equilibrium price. For example, you have a firm that produces pens. Another firm B enters the market with supposedly better features in their pen. Because of that demand for your pen reduces, even though you did not increase prices for your pen. This is explained by downward SHIFT in the demand curve for your pen. In another case, if you had increased prices for your pen and as a result its demand was decreased, it would have been because of movement ALONG the demand curve of your pen.
got it. Thanks.
So actually there wouldn’t be a change in the Industry demand curve, but there would be a shift down in the indidual demand curve?
Industry’s demand curve is not shifted in this case. Only individual firm’s demand curve is. As new firms enter the market, the industry supply curve will shift right, causing a decrease in price and increase in quantity. This is a movement along the industry demand curve, not a shift. Now, the affected firm’s demand curve will not only shift left, but also become more elastic but consumers have more choices to select from. It will produce at the output where MR = MC and generate zero economic profit, and there will not be any new entrants.
Yep got it. thanks again.