Explain why a monopolistically competitive firm can make economic (abnormal) profit in the short run, but not in the long run.

Discuss the consequences of a perfectly competitive market becoming a monopoly market.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of monopolistic competition, economic (abnormal) profit, short run, long run
• diagram of a monopolistically competitive firm that makes economic profit in the short run by producing the quantity of output where MR=MC and price is lower than ATC; diagram of a monopolistically competitive firm that makes normal profit in the long run by producing the quantity of output where MR=MC and price is equal to ATC
• explanation that in the long run the economic profit will disappear, because the lack of barriers to entry in the industry will allow the entrance of new firms, which will attract customers away from existing firms (decreasing the demand)
• examples of monopolistically competitive markets in practice (e.g. restaurants, legal and tax services, dental care).

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definitions of perfect competition, monopoly
• diagrams of a perfectly competitive firm with only normal profit (producing at a level of output that is productively and allocatively efficient) and a monopoly with abnormal profit (producing at a level of output that is productively and allocatively inefficient)
• explanation that the firm that will dominate the industry will be able to charge a higher profit-maximizing price, make economic (abnormal) profit in the long run and produce at a level of output that is neither allocatively nor productively efficient
• examples of cases where a perfectly competitive market may be monopolized are not required, but candidates may use real-world examples of markets that have the characteristics of perfect competition or monopoly in their answers
• synthesis or evaluation (discuss).

Discussion may include: the positive and negative effects on different stakeholders; short-run and long-run effects on prices and economic (abnormal) profit; the consequences for productive and allocative efficiency, innovation, research and development; the possible positive effects of economies of scale.

NB It should be noted that definitions, diagrams, theory and examples that have already been given in part (a), and then referred to in part (b), should be rewarded.

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

Quite a few candidates did not know the exact characteristics of monopolistic competition and were not able to make the link between these characteristics and the inability to make abnormal profit in the long run. 

Most candidates focused on correct but rather theoretical discussions about allocative and productive efficiencies and supported their answers with appropriate diagrams. Much fewer were those which were also able to demonstrate a real-world understanding by discussing the ability of monopolies to invest in R&D and the possible benefits to society from economies of scale.