We first consider the decisions facing an individual firm to understand monopolistically competitive markets. We then examine what happens in the long run as firms enter and exit the industry. Next, we compare the monopolistic competition to the perfect competition. Finally, we consider whether the outcome in a monopolistically competitive market is desirable from the stand point of society as a whole.
Each firm is a monopolistically competitive market in many ways because its product is different from those offered by other firms. Thus the monopolistically competitive firm follows a monopolist’s rule for profit maximization: It chooses the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price consistent with that quantity.
The cost, demand, and marginal revenue for two typical firms is different each in a monopolistically competitive industry. The profit maximizing quantity depends upon the marginal revenue and marginal cost. If the price exceeds average total costs the firm makes a profit. If the price is below average total cost, in this case, the firm is unable to make a positive profit so the best the firm can do is to minimize its losses.
All this should seem familiar. A monopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar.
The situations do not last long. When firms are making profits new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and therefore reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products fall, these firms experience declining profit.
Conversely, when firms are making losses firms in the market have an incentive to exit. As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. In other words, losses encourage exist. As the demand for the remaining firms’ products rises, these firms experience rising profit (that is, declining losses).
This process of entry and exit continues until the firms in the market are making exactly zero economic profit. Once the market reaches this equilibrium new firms have no incentive to enter, and existing firms have no incentive to exit.
Because profit per unit sold is the difference between price and average total cost, the maximum profit is zero.
To sum up, two characteristics describe the long run equilibrium in a monopolistically competitive market:
As in the monopoly market price exceeds marginal cost:
This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward sloping demand curve makes marginal revenue less than the price.
As in a competitive market, price equals average total costs. This conclusion arises because free entry and exit drive economic profit to zero.
The other characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close substitutes, it can earn positive economic profit, even in the long run. By contrast, because there is free entry into a monopolistically competitive market, the economic profit of a firm in this type of market is driven to zero.
Monopolistic versus perfect competition:
The long runs equilibrium under monopolistic competition to the long run equilibrium under perfect competition. There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the mark up.
Excess capacity: Entry and exit drive each firm in a monopolistically competitive market to a point of tangency between its demand and average total cost. Under monopolistic competition, firms produce on the downward sloping portion of their average total cost curves. In a way monopolistic competition contrasts starkly with perfect competition. Free entry in competitive markets drives firms to produce at the minimum of average total cost.
The quantity that minimizes average total cost is called the efficient scale of the firm. In the long run, perfectly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. Firms are said to have excess capacity under monopolistic competition. In other words, a monopolistically competitive firm, unlike a perfectly competitive firm, could increase the quantity it produces and lower the average total cost of production.