Both monopolistic competition and perfect competition have many buyers and sellers and relatively free entry. However, product differentiation allows a monopolistic competitor the ability to have some influence over price. Consequently, a monopolistic competitive firm has a downward sloping demand curve, but because of the large number of good substitutes for its product, it tends to be more elastic than the demand curve for a monopolist.
Because of the downward slope of the firm’s demand curve
in monopolistic competition, its point of tangency with ATC will not and cannot be at the lowest level of average cost. Therefore, even when long-run adjustments are complete, firms will not be operating at a level that permits the lowest average cost of productionCthe efficient scale of the firm. The existing plant, even though optimal for the
equilibrium volume of output, will not be used to capacity. That is,
excess capacity exists at that level of output.
Unlike a perfectly competitive firm, a monopolistically competitive firm could increase output and lower its average total costs. However, any attempt to increase output to attain lower average cost would be unprofitable, because the price reduction necessary to sell the greater output would cause MR to fall below MC of the increased output. Consequently, in monopolistic competition, there is a tendency toward
too many firms in the industry, each producing a volume of output less than that which would allow lowest cost. The term economists use for this is that the firm is failing to reach
productive efficiency.
Productive inefficiency is not the only problem with monopolistic competition. Firms are also not operating where price is equal to marginal cost. At the intersection of MC and MR, price is greater than marginal cost. This means that society is willing to pay more for the product (the price) than it costs society to produce it.
In this case, the firm is failing to reach allocative efficiency, where price equals marginal cost. The firm is underallocating resources--too many firms are producing at less than full capacity. Perfectly competitive firms reach both productive efficiency (P = ATC at the minimum point on the ATC curve) and allocative efficiency (P = MC).
Exhibit 1: Comparing Long-Run Perfect Competition and Monopolistic Competition
In monopolistic competition, the higher average costs and the slightly higher price and lower output may just be the price we pay for differentiated products--variety. Just because we have not met the conditions of productive and allocative efficiencies it is not obvious that society is not better off.
Perfect competition meets the test of allocative and productive efficiency and monopolistic competition does not. So can we “fix” monopolistic competition to look more like an efficient, perfectly competitive firm? Because a monopolistically competitive firm makes no economic profits in the long run, using regulation to force monopolistically competitive firms to equate price and marginal costs would lead to economic losses, because long-run average total costs would be greater than price at P = MC. Consequently, the government would have to subsidize the firm. It might be easier to live with the inefficiencies in monopolistically competitive markets rather than the difficulties in regulating and the cost of subsidizing them.
The excess capacity that exists is the price we pay
for product differentiation, and most of us value some choice.
The inefficiency of monopolistic competition is a result of product differentiation. Because consumers value variety, the loss in efficiency must be weighed against the gain in increasing product variety.
The significance of the difference between the relationship of long-run marginal cost to price in monopolistic competition and in perfect competition can easily be exaggerated. As long as preferences for various brands are not extremely strong, the demand for the products of firms will be highly elastic. Accordingly, the
points of tangency with the ATC curves are not likely to be far above the point of lowest cost, and excess capacity will be small. Only if differentiation is very strong will the difference between the long‑run price level and that which would prevail under perfectly competitive conditions be significant.
Exhibit 2: The Impact of Product Differentiation
Remember: The theory of the firm is like a road map that does not provide every possible detail, but gives us directions to get from one point to another. Any particular theory of the firm may not tell us precisely how an
individual firm will operate, but rather will give us valuable insight into the tendencies
of how firms will react to changing economic conditions, like entry, demand, and cost changes.
