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 although the firms are selling differentiated products, many are still close substitutes, so if one firm raises its price too high, many of its customers will switch to products made by other firms. This elasticity of demand makes it similar to 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, so 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 equals marginal cost, both over the short run and the long run.
Short-Run Profit or Loss
In the short run, a monopolistically competitive firm maximizes profit or minimizes losses by producing that quantity that corresponds to when marginal revenue = marginal cost. If average total cost is below the market price, then the firm will earn an economic profit.
However, if the average total cost is above the market price, then the firm will incur losses, equal to the average total cost minus the market price multiplied by the quantity produced. It will still minimize losses by producing that quantity where marginal revenue equals marginal cost, but eventually the firm will either have to reverse the losses, or it will have to exit the industry.
Long-Run Equilibrium: Normal Profits
If the competitive firms in an industry earn an economic profit, then other firms will enter the same industry, which will reduce the profits of the other firms. More firms will continue to enter the industry until the firms are earning only a normal profit.
However, if there are too many firms, then firms will incur losses, especially the inefficient ones, which will cause them to leave the industry. Consequently, the remaining firms will return to normal profitability. Hence, the long-run equilibrium for monopolistic competition will equate the market price to the average total cost, where marginal revenue = marginal cost, as shown in the diagram below. Remember, in economics, average total cost includes a normal profit.
Because monopolistically competitive firms do not operate at their minimum average total cost, they, therefore, operate with excess capacity. Note in the above diagram 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.
In some cases, a firm will have enough of an advantage to continue earning economic profits, even in the long run. For instance, a business can have an excellent location relative to other locations in the area, which will always give it an advantage over other firms in that local market. Or a firm may have a patent or trademark on its product that prevents competition. In such cases, firms have some degree of market power that would allow 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 average total cost, and would actually lose money selling at their minimum ATC. To use their excess capacity, they would have to produce a quantity equal to their minimum ATC, but they would not be able to sell that amount without lowering their prices, which would either reduce their profits or actually incur losses.
The monopolistic firm also does not achieve allocative efficiency. Allocative efficiency requires that:
Price = Marginal Cost
The monopolistic firm exhibits a downward sloping demand curve. That means that in order to sell more units, it must lower its price, but if it lowers its price, then it must lower its price on all its units. Thus, like a monopoly, marginal revenue continually declines as quantity is increased. 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. Because of this allocative inefficiency, some consumers must forgo the product because of its higher price.
While monopolistic competitive firms achieve neither productive nor allocative efficiency, they do provide a variety of products. The greater the differentiation of the products, the greater the inefficiency. However, this greater diversity is more likely to satisfy consumer tastes, which leads to a more desirable market.