Source: Microeconomic Theory, Texas A&M University
Tags: monopolistic competition, short run profit, long run equilibrium, excess capacity, product differentiation, zero economic profit, demand curve shift, MR equals MC, profit maximisation, entry and exit
A monopolistically competitive firm behaves like a mini-monopolist in the short run, choosing output where MR = MC and earning positive economic profit if price exceeds ATC. In the long run, free entry erodes that profit to zero. The firm ends up producing on the downward-sloping part of its ATC curve, which means it carries excess capacity compared to a perfectly competitive firm.
Monopolistic competition
A market structure with many firms, differentiated products, and low barriers to entry and exit. Each firm has a small amount of market power due to its unique product, but faces competition from close substitutes.
Product differentiation
The process by which firms make their product distinct from competitors' products through branding, quality, features, or location. This is what gives each firm its own downward-sloping demand curve.
Short-run economic profit
Profit earned when price exceeds average total cost at the profit-maximising output level. In monopolistic competition, this is possible in the short run but attracts entry.
Long-run equilibrium (monopolistic competition)
The state where enough entry has occurred that each firm's demand curve is tangent to its ATC curve. Price equals ATC, economic profit is zero, and no further entry or exit occurs.
Excess capacity
The gap between a firm's long-run equilibrium output and its capacity output (the output that minimises ATC). In monopolistic competition, firms always produce less than the quantity that would minimise their average cost.
Capacity output
The level of output at which average total cost is minimised. In the chapter's example, this is 200 units.
A monopolistically competitive firm maximises profit the same way any firm does: produce where MR = MC, then find the price on the demand curve at that quantity.
The Kafka Exterminators example:
Profit-maximising output: 250 homes per month (where MR₁ = MC).
Price at that output: $70 (read from the demand curve at point A).
ATC at that output: $30.
Profit per unit: $70 - $30 = $40.
Total profit: $40 x 250 = $10,000 per month.
The firm earns positive economic profit in the short run because price sits above ATC at the chosen output level.
Positive economic profit attracts new firms into the market. As new firms enter:
Each existing firm's demand curve shifts leftward (from d₁ to d₂), because customers now have more alternatives.
The marginal revenue curve shifts leftward as well (from MR₁ to MR₂).
The firm's profit-maximising output falls (from 250 to 100 in the example).
Entry continues until the demand curve is just tangent to the ATC curve. At the tangency point (point E in the chapter):
Price = ATC = $40.
Economic profit = zero.
Output = 100 homes per month.
No further incentive for entry or exit exists at this point.
In long-run equilibrium, the monopolistically competitive firm operates on the downward-sloping portion of its ATC curve. This creates a gap:
Long-run equilibrium output: 100 units.
Capacity output (where ATC is minimised): 200 units.
Excess capacity: 100 units.
The firm could lower its average cost by producing more, but doing so would mean MR < MC, so profit would turn negative. The firm is stuck producing below its cost-minimising output.
This is the fundamental trade-off of monopolistic competition. Product variety (which consumers value) comes at the cost of each firm operating below full efficiency.
If the demand curve intersected the ATC curve, there would still be a range of output where price exceeds ATC, meaning positive profit, meaning more entry. Entry only stops when the demand curve merely touches ATC at a single point, with no region of profit remaining.
If the demand curve were entirely below ATC, firms would exit until demand shifted right enough to restore tangency.
⚠️ Know the mechanism: short-run profit attracts entry, entry shifts demand left, long-run profit is zero. Be able to trace through each step on a diagram.
⚠️ In long-run equilibrium, P = ATC but P > MC. This is the key efficiency difference from perfect competition, where P = MC in the long run.
⚠️ Excess capacity is the difference between capacity output (minimum ATC) and actual long-run output. Do not confuse it with unused factory space or idle workers.
⚠️ The demand curve is tangent to ATC in the long run. Tangent, not intersecting. If asked to draw the long-run diagram, the demand curve must touch ATC at exactly one point.
⚠️ A common exam mistake is saying monopolistic competition is "just like perfect competition in the long run." Both earn zero economic profit, but the monopolistic competitor produces less output at a higher price than the perfectly competitive firm would.
Q: How does a monopolistically competitive firm maximise profit in the short run?
A: It produces the quantity where MR = MC and charges the price found on its demand curve at that quantity. If price exceeds ATC at that output, the firm earns positive economic profit.
Q: Why does long-run economic profit equal zero in monopolistic competition?
A: Free entry. Positive profit attracts new firms, which take customers away from existing firms, shifting each firm's demand curve leftward. Entry continues until price equals ATC and economic profit is zero.
Q: What is excess capacity, and why does it exist in monopolistic competition?
A: Excess capacity is the gap between a firm's actual long-run output and the output that would minimise its ATC. It exists because the firm's downward-sloping demand curve can only be tangent to ATC on the falling portion of the ATC curve, so the firm never produces enough to reach minimum average cost.
Q: In long-run equilibrium, a monopolistic competitor charges $40, has ATC of $40, and MC of $25. Is this firm allocatively efficient?
A: No. Allocative efficiency requires P = MC. Here, P ($40) > MC ($25), meaning the firm produces less than the socially optimal quantity. This is the cost of product differentiation.
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