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Home > Economics FAQs Blogs > How should the monopolistic competition diagram be drawn to represent short-run supernormal and long-run normal profits?

How should the monopolistic competition diagram be drawn to represent short-run supernormal and long-run normal profits?

Relevant Topics

This question pertains to topics in Microeconomics, such as Market Structures, Monopolistic Competition, Short-run and Long-run profits

Definitions:

Monopolistic Competition: Monopolistic competition is a type of market structure where many firms sell differentiated products. Firms in monopolistic competition have some market power, as each firm's product is unique in some way, but they still face competition from other firms.

Short-run Supernormal Profit:
Supernormal profit, also known as abnormal profit, is when a firm's profit exceeds the normal required rate of return. In the short-run, firms in monopolistic competition can earn supernormal profits.

Long-run Normal Profit:
Normal profit is the minimum level of profit required for a firm to continue operating. In the long-run, due to the lack of barriers to entry in monopolistic competition, other firms are attracted by the supernormal profit, which increases competition and drives the price down, leaving firms with only normal profit.

Detailed Explanation:

In monopolistic competition, a firm in the short-run can set its price above the marginal cost due to product differentiation, allowing it to earn supernormal profits. This can be represented on a diagram where the firm's demand (AR) curve is downward sloping and above the average total cost (ATC) curve at the profit-maximising level of output. The difference between the AR and the ATC represents the supernormal profit.

In the long-run, however, the existence of supernormal profit attracts other firms into the market, increasing the competition. As a result, the demand curve facing the initial firm shifts leftward, leading to a decline in price. This process continues until the firm only earns normal profits. On the diagram, this is represented when the AR curve touches the ATC curve at the profit-maximising level of output.

Recent: 

Restaurants: Consider a local restaurant that introduces a unique dish and starts making supernormal profits. This is likely to attract other restaurants to introduce similar dishes, increasing the competition, and in the long run, the original restaurant will likely end up making only normal profits.

Tech Start-ups:
A tech start-up could introduce an innovative app and make supernormal profits in the short run. However, as the news of its profitability spreads, other companies would enter the market with similar apps, increasing competition and driving the original firm's profits to a normal level in the long run.

Summary:

In monopolistic competition, firms can make short-run supernormal profits due to their ability to differentiate their product and thus price above marginal cost. On a diagram, this is represented by the AR curve lying above the ATC curve at the profit-maximising level of output. However, in the long run, the existence of supernormal profits attracts more firms into the market, increasing competition and thus eroding these supernormal profits. This is represented by the AR curve touching the ATC curve at the profit-maximising level of output, indicating the firm is making normal profits. Real world examples include local restaurants and tech start-ups.

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