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Market Structures, Costs and Revenue: Question 6

Syllabus 7.6.1, 7.6.4

Multiple choice A2 1 mark

Riverside Quarter is a small city district with a large number of independent coffee shops. Each shop sells its own differentiated blend and style of coffee, and any entrepreneur can open or close a coffee shop in the district without significant barriers. Economists classify this market as monopolistic competition rather than perfect competition or monopoly.

In the long-run equilibrium of a monopolistically competitive market such as this, which outcome is correct?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Recall the assumptions and long-run mechanism of monopolistic competition

Monopolistic competition shares one key assumption with perfect competition, freedom of entry and exit, but differs in a second key respect: each firm sells a differentiated product rather than an identical one. Because products are differentiated, each shop’s demand curve slopes downward rather than being horizontal: raising its own price loses it some, but not all, of its customers, since coffee from a rival shop is a substitute rather than a perfect substitute.

If shops are earning supernormal profit in the short run, freedom of entry still allows new shops to open, drawn in by the prospect of profit. As new shops enter, each existing shop’s demand curve shifts left (its market share is spread across more competitors) until supernormal profit has been competed away entirely, leaving only normal profit in the long run. This part of the mechanism is the same as perfect competition.

However, because each shop’s demand curve is still downward-sloping rather than horizontal, the point at which this demand curve becomes tangent to the average cost curve occurs to the left of the average cost curve’s minimum point, not at it. This means each shop settles at an output below the level needed for productive efficiency, leaving it with spare, or excess, capacity, and because price still exceeds marginal cost at this output, the shop is not allocatively efficient either.

Step 2: Evaluate each option

  • Option A: incorrect. Product differentiation gives a shop only limited, not lasting, market power, free entry still competes away any supernormal profit over time.
  • Option B: correct. This matches the mechanism above exactly: normal profit only, but output below the productively efficient point because of the downward-sloping demand curve, leaving excess capacity.
  • Option C: incorrect. This describes the long-run equilibrium of perfect competition, where a horizontal demand curve is tangent to average cost exactly at its minimum; a monopolistically competitive shop’s downward-sloping demand curve cannot be tangent at that same point.
  • Option D: incorrect. Blocking new entrants describes a barrier to entry, which contradicts the free entry and exit that defines monopolistic competition.

Final answer

Option B, free entry drives long-run profit down to normal profit only, but because each shop faces a downward-sloping demand curve for its differentiated product, its output settles below the productively efficient level, leaving it with excess capacity.