11175 Introduction to Economics

Answers to exam review questions module 7

Compare your responses to those provided below.

Question 1
What effect does the entry of new firms in a monopolistically competitive market have on the economic
profits of existing firms in the market? How might existing firms attempt to counteract this effect?

New firms entering an industry cause the demand curves for the products of existing firms
to shift to the left. Existing firms will be able to sell less at every price, so their profits will
decline. If existing firms can find new ways to differentiate their products or find new ways
to lower their cost of production, they have a better chance of maintaining profits as other
firms enter the market.

Question 2
Explain the similarities and differences between the long-run equilibrium for a perfectly competitive firm
and a monopolistically competitive firm. Illustrate your answer with a graph demonstrating the long-run
equilibrium for the two types of firms.

Refer to the graph above. For both types of firms, in long-run equilibrium, output satisfies MR
= MC (that is, firms maximise profits), although this condition yields different output levels
for the two firms as depicted in the graph. The perfectly competitive firm faces the demand
curve Da and produces output Qa while the monopolistically competitive firm faces demand
curve Db and produces a lower output level, Qb. The perfectly competitive firm charges a
lower price, Pa, compared to the price the monopolistically competitive firm charges, Pb.
However, both firms break even.

The perfectly competitive firm achieves both allocative efficiency (P = MC) and productive
efficiency (lowest possible average cost). This is not the case for the monopolistic

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competitor since its price exceeds the marginal cost of producing the last unit and the
output level is not consistent with the lowest average cost.

Question 3
How does the demand curve for an oligopoly firm differ from the demand curves for firms in
competitive market structures?

The demand curve facing a perfectly competitive firm is horizontal at the prevailing market
price. In other words, the perfect competitor does not influence market price; rather it takes
the price as given. A firm in oligopoly can influence market price and therefore face a
downward-sloping demand curve. But not much else can be said about its demand curve
because firms in oligopoly are interdependent, that is, each firm reacts to its rivals'
behaviours, or at least to what it thinks its rivals will do. Consequently, it is difficult to
determine an individual oligopolist's demand curve.