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

In the long run, a typical monopolistically competitive firm earns only normal profit. Which process best explains this outcome?

Entry of new firms erodes supernormal profit. As entrants take customers, each existing firm's demand curve shifts left until it just touches average cost, so price equals average cost and profit is normal. This is possible because entry is free in monopolistic competition.

  1. AEntry of new firms shifts each firm's demand curve left until price equals average costCorrect
  2. BGovernment regulation fixes price at marginal cost
  3. CFirms collude to restrict output
  4. DExit of firms shifts each firm's demand curve right until price exceeds average cost
  5. Barriers to entry prevent any change in the number of firms

Explanation

Supernormal profits attract entrants, who take away part of each existing firm's demand. Demand shifts left until it is tangent to the average cost curve, so price equals average cost and only normal profit remains. Option 3 describes the reverse process, which applies to losses.

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