- The Firm’s Profit-Maximizing Decision
- Facing a downward-sloping demand curve, a firm in monopolistic competition chooses its profit-maximizing price and quantity as does a monopoly.
- The firm produces at the quantity that sets marginal revenue equal to marginal cost. The firm charges the price that buyers are willing to pay for this quantity, which is determined by the demand curve.
- Economic profit in the short run is possible and equals quantity ´ (price – average total cost).
- Profit Maximizing Might Be Loss Minimizing
If price is less than average total cost, a firm in monopolistic competition incurs an economic loss.
- Long Run: Zero Economic Profit
- There is no restriction on entry in monopolistic competition, so if firms in monopolistic competition are earning an economic profit, other firms to enter the industry. As new firms enter, an individual firm’s demand and marginal revenue decrease. New firms enter until economic profit disappears and the remaining firms earn normal profit.
- If firms in monopolistic competition are incurring an economic loss, some firms leave the industry. As firms exit, a remaining firm’s demand and marginal revenue increase. Firms exit until economic loss disappears and the remaining firms earn normal profit.
- Monopolistic Competition and Perfect Competition
Excess capacity occurs when the quantity that a firm produces is less than the quantity at which average total cost is a minimum. A firm with excess capacity produces below its efficient scale, which is the quantity at which average total cost is a minimum.
Markup is the amount by which price exceeds marginal cost. A firm in monopolistic competition has a markup because price exceeds marginal cost but a firm in perfect competition has no markup.
- Monopolistic Competition and Efficiency
- Making the Relevant Comparison
A firm in monopolistic competition chooses a profit-maximizing quantity where the markup is positive (price is greater than marginal cost), which means that marginal benefit exceeds marginal cost. This choice implies that the firm inefficiently uses resources. (Efficiency requires that price = marginal benefit = marginal cost). But a benefit of monopolistic competition is that it creates product variety.
- The Bottom Line
Compared to the alternative—complete product uniformity—monopolistic competition is efficient.