The action in a monopolistically competitive market occurs when the market moves to the long run. Since other competitors selling a similar good can enter the market, two changes will occur:
As more firms enter the market, the demand for any one firm will decrease, since the firm is now sharing the market with other firms.
A decrease in demand implies a leftward shift in the demand curve. Since the entering firms are producing substitutes for the existing firms good, the demand for the existing good will become more elastic. An increase in elasticity implies the demand curve is getting flatter. By combining these effects, as a monopolistically competitive market moves from short-run profits to the long run, the firms demand curve will move to the left and get flatter. Furthermore, the demand curve will continue to move until there are no more firms entering the market. Firms will stop entering the market when profits are zero.
This occurs when the demand curve just barely touches (i.e., is tangent to) the ATC curve, as shown in the figure above. Once the demand curve is tangent to the ATC curve, the profit-maximizing price is equal to the average total cost, and thus, profits are zero. In the long run, competition will drive monopolistically competitive markets to make zero profits. The goal of the firm is to try to maintain as much short-run profit as possible by differentiating its product. Eventually, though, in the long run, economic profits will be zero.
If a monopolistic competitor is losing money in the short run, the opposite holds true. If the market is not profitable, firms will leave as the market moves towards the long run. When firms leave, there are fewer substitutes, so demand becomes more inelastic and increases since market demand is split up among more firms. The demand curve keeps getting steeper and moving to the right until it is tangent to the ATC curve, where profits become zero and no other firms want to leave the market. (This would occur at point A in panel (b) of the earlier figure.)
For more practice monopolistic competition models, try the following Active Graph Level Two exercise: