The tutor looks into monopolistic competition and the long-run trend faced by its entrants.

Monopolistic competition exists, in a given business, when there is free entry – that is, when starting a new enterprise engaged in that business is easy. An example might be lawn care. Theoretically, anyone with a lawn mower and possibly a few other implements can start a lawn care business and win market share. The result is that, with monopolistic competition, there tend to be numerous, small, local firms engaged in that same business.

A given firm facing monopolistic competition can generate long-term profit. However, the typical trend faced by a firm in monopolistic competition is as follows:

1. At first, there is much more demand than supply, inducing one or two “startups”. Those early firms enjoy a few years of rewarding profitability.
2. Noticing the profitability of the original “startups”, other people decide to join that same market: they start firms that engage in the same business. They can do so easily because there is free entry.
3. Eventually, enough new firms start so that each has a relatively small portion of the market – to the point that each firm’s market share is only enough to cover its overhead. On average, the profitability of the business is zero.

An economist, using more technical language, might explain the above scenario as follows:

As long as demand exceeds supply, the firm can set its price above its cost per unit and enjoy profitability. However, as competition emerges, supply increases, so the firm loses its power to set its own price, yet maintain its market share. With free entry, competition will be plentiful, so supply will surely grow. Eventually, the typical firm will only be able to charge enough to cover its costs. When production is within capacity, the cost per unit decreases as more units are sold. Therefore, if the firm could sell more units for the same price, its unit cost would decrease, allowing profit; however, with so much competition, it cannot expect to increase its market share. In the case of monopolistic competition, the early entrants to the market might likely enjoy short-run profitability, but long-run profitability will typically be zero.

Source:

Parkin, Michael and Robin Bade. Economics: Canada in the Global Environment, 2nd ed. Don Mills: Addison-Wesley, 1994.

Jack of Oracle Tutoring by Jack and Diane, Campbell River, BC.