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CA Foundation · Business Economics · Price Determination in Different Markets

A restaurant in a city market with many differentiated eateries is currently earning supernormal profits. According to the theory of monopolistic competition, what is the most likely long-run consequence?

New firms will enter, shifting the demand curve of existing firms leftward until supernormal profit disappears. Free entry attracts rivals with close substitutes, which takes away customers. The process stops when price equals average cost and the firm earns only normal profit.

  1. ANew firms enter, shifting the demand curve of existing firms leftward until supernormal profit disappearsCorrect
  2. BExisting firms exit, shifting the demand curve rightward
  3. CThe restaurant becomes a monopolist because of its brand
  4. DThe firm's marginal cost curve shifts permanently upward due to taxes

Explanation

Entry is free under monopolistic competition, so supernormal profits attract new firms offering close substitutes. Each existing firm loses customers, so its demand curve shifts left and becomes more elastic. This continues until price equals average cost and only normal profit remains. Exit and rightward shifts occur when firms make losses.

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