Explain how price and output are determined for a firm in a monopolistically competitive market, in both the short run and the long run

AQA A-Level Economics Paper 1 June 2017

Explain how price and output are determined for a firm in a monopolistically competitive market, in both the short run and the long run. (15 marks)

1. Monopolistic competition is a market structure with low barriers to entry and slight product differentiation. 
2. The diagram below shows a firm’s cost and revenue curves in the short-run.
3. Firms are profit maximisers so they would set output and price where marginal cost equals marginal revenue
4. The firm reads down from the point where MC = MR to determine their output.
5. From this output, average revenue shows the price that they can charge customers, and average cost shows the cost.
6. Therefore the shaded rectangle shows the firm’s supernormal profit.

1. Since existing firms are making supernormal profit, new firms are incentivised to join the market. 
2. This is possible since there are low barriers to entry.
3. As a result, market supply increases. 
4. Each firm therefore loses market share causing marginal revenue and average revenue to decrease.
5. The diagram below shows that in the long-run, firms are only able to make normal profits.
6. Firms continue to aim to profit maximise so they set output at the level where MC=MR.
7. At this point, average revenue is equal to average cost.
8. Normal profit is the level of profit needed to stay in business. 
9. It means that the level of profit equals the opportunity cost of running the business.

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