Question

Which of the following statements are true? Explain why.

(i) A firm in a monopolistically competitive market sets price equal to average cost

in the short run.

(ii) A firm in a monopolistic market sets price equal to average cost in the long run.

(iii) A firm in a monopolistically competitive market chooses sets price equal to

marginal cost in the long run.

Answer 1

Statement three is correct

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (MR and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit.

Pricing Power

As in a monopoly, firms in monopolistic competition are price setters or makers, rather than price takers. However, the firms nominal ability to set their prices is effectively offset by the fact that demand for their products is highly price elastic. In order to actually raise their prices, the firms must be able to differentiate their product from their competitors by increasing its quality, real or perceived.