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CA Foundation · Business Economics · Price Determination in Different Markets

Under monopolistic competition, firms earn only normal profits in the long run despite having some pricing power in the short run. Which factor is primarily responsible for the elimination of supernormal profits?

New firms enter a monopolistically competitive market when supernormal profits exist, reducing demand faced by existing firms until price falls to equal average cost, leaving only normal profits in long-run equilibrium.

  1. AThe government imposes taxes on excessive profits
  2. BNew firms enter the market attracted by short-run supernormal profits, increasing competitionCorrect
  3. CThe central bank controls the money supply, raising interest rates
  4. DConsumer preferences shift away from differentiated products toward homogeneous goods

Explanation

In monopolistic competition, positive economic profits in the short run attract new entrants because barriers to entry are low. As new firms enter, each existing firm's share of market demand falls, shifting its demand curve leftward until price equals average cost, yielding only normal profits. Taxation, monetary policy, and consumer preference shifts are not the defining mechanism of long-run equilibrium in this market structure.

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