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CA Foundation · Business Economics · Price Determination in Different Markets

A firm in monopolistic competition is earning supernormal profits in the short run. According to the standard theory, what is the likely long-run outcome?

New firms will enter because entry is free, and this shifts the demand curve of existing firms leftward. The process continues until price equals average cost and only normal profit is earned. Supernormal profit therefore cannot persist in the long run under monopolistic competition.

  1. ANew firms enter, shifting the demand curve of existing firms to the left until profits are normalCorrect
  2. BExisting firms exit, shifting demand to the right
  3. CThe firm becomes a monopolist and keeps supernormal profits
  4. DPrice rises to the level of marginal cost plus a fixed mark-up forever

Explanation

Free entry and exit exist in monopolistic competition. Supernormal profits attract new entrants with similar products, which takes away customers and shifts each existing firm's demand curve leftward. This continues until price equals average cost and only normal profit remains. Exit of firms would occur under losses, not profits.

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