The graph to the left shows a firm operating under monopolistic competition. It will choose to produce at MR=MC and hence will make a short run abnormal profit as shown by the highlighted rectangle. It is possible for a firm to make a loss in the short run and it would only remain in business if the price was greater than the average variable cost (P>AVC).
Because we assume free entry into the market any supernormal profits will attract new firms into the market. The new firms (that have entered) will make differentiated products. The effect of this will be to attract customers away from the incumbent firm (and hence cause demand to shift leftwards) and as there are now more substitutes to the original product the demand curve will become more elastic. New firms will continue to enter the market whilst profits exist a process which begins to eliminate profits (by shifting the demand curve, marginal revenue will also fall). This process may be accelerated by firms increasing advertisement in a bid to defend their market share. This will help to keep the demand curve downward sloping (inelastic) but will increase average costs. The graph to the left shows the long run equilibrium when no abnormal profits are being made.
Efficiency of Monopolistic Competition
In the long run neither productive nor allocative efficiency is attained. This is because the price is above the marginal cost meaning the market is allocatively inefficient. Firms in monopolistic competition also produce at a level of output below the minimum of average costs making the productively inefficient this indicates that firms produce at a level less than the optimum capacity.
The shaded triangle shows welfare loss. In the long run the number of firms in monopolistic competition is inefficient as there are too many firms creating externalities.
There is a positive product variety externality as consumers are getting a wider choice of differentiated products. Simultaneously there is a negative business stealing externality arising from new firms pinching customers from incumbent firms.
Advertising can have negative effects by stipulating consumers tastes, promoting brand loyalty and raising the costs for the firm and hence the price for the consumers. Due to the large number of competitors, the firm isn’t producing at its minimum total costs because it can’t produce enough output. If there were fewer firms then the firm could produce more and may reach its minimum point on its average cost curve which would benefit society. However it could be argued that there is a benefit to consumers from the wide range of choice they have. Also the fact that they pay a premium to purchase their favourite brands shows that they prefer it to any substitutes.
It could also be argued that firms operating under monopolistic competition are less likely to be operating at X-inefficiency than monopolies as they try to keep costs down in order to maximise profits.
