Answer to Question #275055 in Microeconomics for Neha Nair

Question

Why is it the case in a long-run monopolistically competitive equilibrium that the firm’s demand curve is tangent to its average cost curve? Why could it not be a long-run equilibrium if the demand curve “cut through” the average cost curve? (Max. 500 words)

Answer 1

In a monopolistically competitive market, each firms demand curve will be tangent to its

average cost curve because there is free entry and exit of firms, so

firms will enter if there are any economic profits to be earned. This entry will occur until economic profits are driven to zero, much like the perfectly competitive environment. When economic profits are zero, it must be the case that price is equal to average cost since profit can be written as $\pi=(P-AC)Q$. If price is equal to average cost, then the demand curve must touch the average cost curve at the optimal quantity. This is seen as a tangency between demand and average cost in the long run.

If demand 'cut through' the average cost curve, then there would be a range of outputs over

which economic profit would be positive. This would entice new firms to enter, driving profits

down. Therefore, the demand curve 'cutting through; the average cost curve cannot be an

equilibrium in the long run since new firms will enter