AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/4/4-4)
Unit 4 · Topic 4.4
4.4 Monopolistic Competition
Monopolistic competition has many firms selling products that are similar but not identical, with easy entry and exit. Each firm has a little market power in the short run, but entry and exit push economic profit to zero in the long run. Even then, these firms make less than the quantity at minimum average cost and charge more than marginal cost.
Key terms
- monopolistic competition
- product differentiation
- non-price competition
- free entry and exit
- zero economic profit
- excess capacity
What the market looks like
Think of restaurants, coffee shops, hair salons or clothing brands. There are many sellers, and each one's product is a bit different: location, style, quality, brand. That's product differentiation.
Because your burger isn't exactly like the burger down the street, you can raise your price a little without losing every customer. So each firm faces a downward-sloping demand curve, with MR below it, just like a monopoly. But there are lots of close substitutes, so that demand curve is fairly elastic.
Firms compete with non-price competition: advertising, branding, better service, new features. The goal is to make your product seem more special, which makes your demand bigger and less elastic.
- Many firms, each small relative to the market.
- Differentiated products.
- Easy entry and exit (low barriers).
- Some market power: a downward-sloping demand curve.
The short run
In the short run, a monopolistically competitive firm acts just like a monopoly. It produces where MR = MC and charges the price on its demand curve at that quantity. Depending on where ATC is, it can earn a profit, break even or take a loss. The graph is the same as the monopoly graph in 4.2.
The long run: entry and exit
If firms are earning economic profit, new firms enter, because entry is easy. Customers spread across more sellers, so each existing firm's demand curve (and its MR curve) shifts left. Entry continues until profit is gone.
If firms are taking losses, some exit. The remaining firms pick up their customers, so each firm's demand curve shifts right until losses are gone.
The long-run equilibrium: the firm's demand curve is just tangent to (touches without crossing) its ATC curve, at the quantity where MR = MC. At that point P = ATC, so economic profit is zero. This is the same zero-profit result as perfect competition, for the same reason: free entry.
Describing the long-run graph in words
Price on the vertical axis, quantity on the horizontal. Draw a downward-sloping demand curve, an MR curve below it, a U-shaped ATC curve and an MC curve through the bottom of ATC. Demand touches ATC at exactly one point, on the downward-sloping part of ATC, to the left of ATC's minimum. MR crosses MC at the quantity directly below that tangency point.
The price is at the tangency point, where P = ATC. Since demand slopes down, the tangency can't be at the bottom of the U. So the quantity is less than the quantity at minimum ATC.
How efficient is it?
- Not productively efficient: the firm produces less than the quantity at minimum ATC. The gap between its output and that quantity is called excess capacity. Each firm could lower its average cost by producing more.
- Not allocatively efficient: P > MC at the profit-maximizing quantity, so there is deadweight loss.
- Zero economic profit in the long run, like perfect competition and unlike monopoly.
- The trade-off: buyers get variety. Many economists see the higher cost as partly the price of having many different products to choose from.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
From short-run profit to long-run equilibrium
A monopolistically competitive bubble tea shop is earning an economic profit. Explain what happens in the long run to (a) the number of shops, (b) this shop's demand curve, (c) its price and quantity, and (d) its economic profit.
Show the solutionHide the solution
- Step 1: (a) Economic profit means owners are earning more than they could elsewhere, and entry is easy, so new shops open.
- Step 2: (b) Customers now have more choices, so each existing shop gets fewer customers at any price. Its demand curve shifts left, and its MR curve shifts left with it. (With more close substitutes, demand also tends to become more elastic.)
- Step 3: (c) The shop again produces where MR = MC and charges the price on its new, lower demand curve. Entry continues until demand is tangent to ATC.
- Step 4: (d) At that tangency, P = ATC, so economic profit is zero. Entry stops because there's no profit left to attract new shops.
Answer: Shops enter; each shop's demand and MR shift left until demand is tangent to ATC; price falls to equal ATC; economic profit falls to zero.
- Example 2
Excess capacity and markup in long-run equilibrium (classic trap)
A monopolistically competitive firm is in long-run equilibrium. It produces 300 units, where MR = MC = $8, and charges $12. Its ATC at 300 units is $12. ATC reaches its minimum of $10 at 400 units. (a) What is its economic profit? (b) How much excess capacity does it have? (c) Is it allocatively efficient? (d) A classmate says that, since profit is zero, this market is as efficient as perfect competition. Is that right?
Show the solutionHide the solution
- Step 1: (a) Profit = (P − ATC) × Q = (12 − 12) × 300 = $0. Zero economic profit is what long-run equilibrium means here.
- Step 2: (b) Excess capacity = quantity at minimum ATC − actual quantity = 400 − 300 = 100 units.
- Step 3: (c) No. Price ($12) is above marginal cost ($8), so buyers value one more unit more than it costs to make.
- Step 4: (d) No. Zero profit is the same as perfect competition, but efficiency isn't. A perfectly competitive firm in the long run produces at minimum ATC with P = MC. This firm has P > MC and produces where ATC ($12) is above its minimum ($10).
Answer: (a) $0. (b) 100 units. (c) No, because P = $12 > MC = $8. (d) No: zero profit doesn't mean efficient. The firm is neither allocatively nor productively efficient.
Common mistakes
- Drawing the long-run tangency at the bottom of the ATC curve. That's perfect competition. In monopolistic competition the tangency is on the downward-sloping part of ATC.
- Shifting the ATC curve when firms enter. Entry shifts each firm's demand and MR curves left; costs don't change.
- Saying zero economic profit means the owner earns nothing. It means the owner earns a normal profit, just enough to cover opportunity costs (3.4).
- Mixing up monopolistic competition with monopoly. Monopolistic competition has many firms and easy entry, so long-run profit is zero.
On the exam
- A favorite question: describe the long-run equilibrium graph and explain why profit is zero, or show the adjustment from short-run profit or loss. Say which curves shift (demand and MR) and why (entry or exit).
- Know the comparison table: in the long run, monopolistic competition has P = ATC (zero profit) but P > MC and output below minimum ATC.
Connected topics
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Check yourself
4 questions on 4.4 Monopolistic Competition. Pick an answer to see if you got it, and why.
The graph shows a firm in a monopolistically competitive industry. Price and cost in dollars are on the vertical axis, and quantity is on the horizontal axis.
The firm's demand curve slopes downward and just touches (is tangent to) its U-shaped average total cost (ATC) curve at a quantity of 30 and a price of $12. Its marginal revenue (MR) curve lies below the demand curve.
MR and marginal cost (MC) intersect at a quantity of 30, where MC is $8.
The ATC curve reaches its minimum of $10 at a quantity of 45.
Hypothetical graph described in words
What is the firm's economic profit?
Which of the following best describes this firm's situation?
How much excess capacity does this firm have?
Which statement correctly describes this firm's efficiency?
0 of 4 answered