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IAI Actuarial Core Principles · Business Economics · Profit maximisation under imperfect competition

A monopolistically competitive restaurant in Pune is earning abnormal profit in the short run. Which long-run outcome is most likely, other things equal?

Entry by new firms shifts the restaurant's demand curve to the left until price equals average cost, leaving only normal profit. Differentiation does not protect abnormal profit because free entry brings in close substitutes that take away its customers.

  1. ANew entrants shift its demand curve left until price equals average costCorrect
  2. BIts demand curve shifts right as rivals exit
  3. CThe firm continues to earn abnormal profit because of product differentiation
  4. DPrice falls to the minimum point of its average cost curve
  5. Marginal cost rises until it equals average revenue at a higher output

Explanation

Abnormal profit attracts entrants offering close substitutes, which takes customers from existing firms and shifts each firm's demand curve left and makes it more elastic. This continues until AR equals AC, giving normal profit. Tangency occurs on the falling part of AC, not at its minimum.

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