Monopolistic Competition: Short-Run Profits and Losses, and Long-Run Equilibrium
Monopolistic competition is the economic market model with many sellers selling similar, but not identical, products. The demand curve of monopolistic competition is elastic because though the firms are selling differentiated products, many are still close substitutes, so if one firm raises its price too high, many customers will switch to products made by other firms. This elasticity of demand is like pure competition, where elasticity is perfect. Demand is not perfectly elastic because a monopolistic competitor has fewer rivals than would be the case for perfect competition, and because the products are differentiated to some degree, they are not perfect substitutes.
Monopolistic competition has a downward-sloping demand curve. Thus, just as for a pure monopoly, its marginal revenue will always be less than the market price because it can only increase demand by lowering prices, but by doing so, it must lower the prices of all units of its product. Hence, monopolistically competitive firms maximize profits or minimize losses by producing that quantity where marginal revenue = marginal cost, both over the short and long run.
Short-Run Profit or Loss
In the short run, a monopolistically competitive firm maximizes profit or minimizes losses by producing that quantity where marginal revenue = marginal cost. If the average total cost is below the market price, the firm will earn an economic profit.
- D = Market Demand
- ATC = Average Total Cost
- MR = Marginal Revenue
- MC = Marginal Cost
This graph shows that the market price charged by the monopolistic competitive firm = the point on the demand curve where MR = MC.
Short-Run Profit = (Price − ATC) × Quantity
However, if the average total cost exceeds the market price, the firm will suffer losses equal to the average total cost minus the market price multiplied by the quantity produced. Losses will still be minimized by producing that quantity where marginal revenue = marginal cost, but eventually, the firm either must reverse the losses or be forced to exit the industry.
Short-Run Loss = (ATC − Price) × Quantity
Long-Run Equilibrium: Normal Profits
If the competitive firms in an industry earn an economic profit, other firms will enter the same industry, reducing the profits of the other firms. More firms will continue to enter the industry until the firms are earning only a normal profit.
However, too many firms will causes losses, forcing inefficient firms to exit the industry. Consequently, the remaining firms will return to normal profitability. Hence, the long-run equilibrium for monopolistic competition exists when market price = average total cost, where marginal revenue = marginal cost, as shown in the diagram below. Remember, in economics, the average total cost includes a normal profit.
Note that where MC rises above MR, the costs exceed additional revenue, so the firm maximizes its profit by producing only that quantity where MR = MC and charging the price at position 1 in the graph.
2 Market Price = Marginal Cost = Allocative Efficiency
3 Productive Efficiency = Minimum ATC
Excess Capacity = Quantity Produced at Minimum ATC − Quantity yielding the greatest profit (MR = MC).
Because monopolistically competitive firms do not operate at their minimum average total cost, they operate with excess capacity. The above diagram shows that firms would lose money if they produced more to achieve either allocative or productive efficiency. That most firms operate with excess capacity is evident when looking at most monopolistically competitive firms, such as restaurants and other retailers, where salespeople are often idle.
Some firms may have enough advantage to continue earning economic profits, even in the long run. For instance, a business with an excellent location relative to other locations in the area will always have an advantage over other firms in that local market. Or a firm may have a patent or trademark that prevents competition. In such cases, firms have some market power, allowing them to price their products above competitors' prices without losing too much business.
Productive and Allocative Efficiency of Monopolistic Competition
Productive efficiency requires that:
Price = Minimum Average Total Cost
Pure competition can achieve productive efficiency, but most monopolistic competitive firms do not since they sell at a price higher than the minimum ATC and would lose money selling at their minimum ATC. To use their excess capacity, they must produce a quantity equal to their minimum ATC, but they cannot sell that amount without lowering their prices, thus either reducing their profits or incurring losses.
The monopolistic firm also does not achieve allocative efficiency. Allocative efficiency requires that:
Price = Marginal Cost
The monopolistic firm has a downward-sloping demand curve. To sell more units, it must lower its price, but if it lowers its price, it must lower the price on all units. Thus, like a monopoly, marginal revenue continually declines as quantity increases. The firm maximizes profits when marginal revenue = marginal cost, but this only occurs at a quantity less than what a purely competitive firm would produce, where marginal cost = market price. The marginal cost curve will always intersect the marginal revenue curve before it intersects the demand curve because, as previously stated, at any given quantity, marginal revenue is always less than the market price. Due to this allocative inefficiency, some consumers will forgo the product due to its higher price.
Thus, monopolistic competitive firms achieve neither productive nor allocative efficiency: the greater the differentiation of the products, the greater the inefficiency. However, monopolistic competition creates a greater variety of products and services, and this greater diversity is more likely to satisfy consumer tastes, which leads to a more desirable market.