Many Thai restaurants operate in a city under monopolistic competition. A popular new Thai restaurant opens nearby. In the long run, what happens to the economic profit of existing Thai restaurants?
AIt increases — more restaurants attract more customers to the area overall
BIt remains positive — product differentiation protects each firm's market power from new entrants
CIt falls to zero — free entry shifts each incumbent's demand curve leftward until economic profit is eliminated
DIt falls to zero only if the new restaurant is an exact substitute; differentiation prevents full profit erosion
Free entry is the key mechanism. New entrants steal customers from incumbents, shifting each firm's demand curve leftward and making it more elastic. This reduces both price and quantity for existing firms. Entry continues until economic profit reaches zero. Product differentiation gives each firm a downward-sloping demand curve (some market power), but it does not prevent the profit-eroding effect of free entry. The same mechanism operates in perfect competition; the long-run equilibrium condition is the same, but the location on the LRAC curve differs.
Question 2 Multiple Choice
In the long-run equilibrium of a monopolistically competitive market, what is the primary source of economic inefficiency?
AFirms produce below minimum efficient scale, resulting in excess capacity and price above marginal cost
BFirms earn accounting losses that prevent them from covering fixed costs in the long run
CAdvertising expenditures by firms generate negative externalities for competing firms
DConsumer welfare is reduced because there are too many product varieties to evaluate
In long-run monopolistic competition, the demand curve is tangent to the LRAC curve to the left of its minimum. Firms operate with excess capacity — producing less than the output that minimizes average cost. At this tangency point, P = LRAC (zero economic profit) but P > MC and LRAC > min LRAC. Both signal inefficiency: P > MC means allocative inefficiency, and LRAC > min LRAC means productive inefficiency. This is the 'cost of variety': society gets differentiated products but pays in higher average costs than a world of standardized goods would require.
Question 3 True / False
In long-run equilibrium, both perfect competition and monopolistic competition achieve P = LRAC (zero economic profit), so they have identical efficiency outcomes.
TTrue
FFalse
Answer: False
Both reach P = LRAC, but the location on the LRAC curve is fundamentally different. In perfect competition, P = min LRAC — firms operate at efficient scale, the lowest possible average cost. In monopolistic competition, the tangency condition gives P = LRAC at a point above and to the left of the minimum, meaning firms have excess capacity and higher-than-minimum average cost. The zero-profit condition is the same; the efficiency properties are not.
Question 4 True / False
Product differentiation gives each firm in monopolistic competition a downward-sloping demand curve, even after long-run entry drives economic profit to zero.
TTrue
FFalse
Answer: True
Unlike perfectly competitive firms (horizontal demand curves), monopolistically competitive firms face downward-sloping demand because their products are imperfect substitutes. Consumers who prefer a specific brand won't immediately switch when the price rises slightly. This market power persists in long-run equilibrium — what free entry eliminates is the profit, not the market power. In long-run equilibrium the demand curve is still downward-sloping; it has shifted leftward until it is tangent to the LRAC curve.
Question 5 Short Answer
Explain why long-run zero economic profit in monopolistic competition does not mean the market is productively efficient, using the concept of excess capacity.
Think about your answer, then reveal below.
Model answer: In monopolistic competition's long-run equilibrium, the demand curve is tangent to the LRAC curve to the left of the minimum point. Each firm produces less than the output that would minimize average cost — it operates with excess capacity. Average cost is higher than the minimum achievable, so resources aren't used as efficiently as possible. Productive efficiency requires P = min LRAC (as in perfect competition); here P = LRAC > min LRAC. Zero economic profit only means firms cover their costs — not that they cover them at the lowest possible cost per unit.
The excess capacity result is the 'cost of variety': society gets more differentiated products but pays in higher average costs than a standardized-goods world would require. Whether the variety is worth the inefficiency is normative, but the productive inefficiency itself is unambiguous. This is the key contrast to memorize: zero profit is the same condition in both market structures; excess capacity is what makes monopolistic competition distinctively inefficient.