Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Monopolistic competition
Compare short-run profit and loss with long-run normal profit in monopolistic competition. Explain entry, excess capacity and product differentiation.
The economic idea
Monopolistic competition is a market structure with many firms, differentiated products and relatively low barriers to entry and exit. Branding, quality, location and service make products imperfect substitutes and give each firm some price-setting power.
Like other firms with market power, the firm faces downward-sloping demand, so MR lies below AR. It chooses output where MR = MC and reads price from demand. In the short run it may earn abnormal profit, normal profit or a loss.
If firms earn abnormal profit, entry provides consumers with more substitutes and reduces the demand faced by each existing firm. If firms make losses, exit increases the demand available to survivors. Long-run equilibrium occurs when the firm’s demand curve is tangent to AC at the MR = MC output, giving normal profit.
Because tangency normally occurs on the downward-sloping section of AC rather than at minimum AC, the firm produces below the output that minimises average cost. The difference is excess capacity: the gap between profit-maximising output and the minimum-AC output.
The firm also has P > MC in long-run equilibrium, so it is not allocatively efficient in the static sense. Consumers may nevertheless value variety, location and innovation, which are not captured by a simple homogeneous-product efficiency benchmark.
Reading a short-run monopolistically competitive firm
“D = AR” is downward sloping because differentiation gives the firm limited market power. “MR” lies below it.
“MC” determines the marginal output choice; “AC” determines profit and the minimum-cost capacity benchmark.
“E” marks the firm’s chosen output and price. “C” marks minimum AC only when the long-run capacity point is displayed.
Profit maximisation at E
The firm chooses “Q” where “MR” meets “MC”, then reads “P” from “D = AR”.
Current short-run profit
“E” is a short-run outcome where “MR” equals “MC”. “P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output. It should not be labelled long-run equilibrium unless demand is tangent to AC.
Capacity and static efficiency
The current graph does not show the standard gap between chosen output and minimum-AC output, so excess capacity should not be asserted from appearance alone.
Normal profit does not remove every inefficiency
Use “P” and the height of “AC” at “Q” to assess economic profit. Do not use the gap between price and “MC” as profit per unit; that gap concerns the marginal efficiency test.
The graph currently shows a short-run position. Explain entry or exit as a possible later adjustment, not as an event that has already happened. Normal profit in the long-run model still allows a return to the entrepreneur because that return is included in economic cost.
How entry or exit produces long-run tangency
In the short run, the firm chooses “Q” where “MR” equals “MC” and charges “P” on demand.
Abnormal profit attracts entrants. More substitutes reduce each incumbent firm’s demand and make it more price elastic.
Long-run equilibrium requires “D = AR” to be tangent to “AC” at the output where “MR” equals “MC”.
What the current state establishes
An efficiency conclusion requires a readable comparison with minimum AC and MC.
Common mistakes to avoid
- Monopolistic competition is not monopoly: it contains many firms and relatively easy entry, despite product differentiation.
- Normal profit requires demand to be tangent to AC at the MR = MC output; merely seeing the curves cross is insufficient.
- Excess capacity is the gap from the minimum-AC output, not proof that factories or workers are literally idle.
- Product variety can create consumer benefit, so static inefficiency does not by itself settle the welfare judgement.
How to draw this diagram
- Title the diagram “Monopolistic competition”. Label the horizontal axis “Quantity” and the vertical axis “Price, costs, revenue”.
- Draw D = AR first and label it clearly.
- Draw MR next and label it clearly.
- Draw MC next and label it clearly.
- Draw AC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model treats product differentiation through a single demand curve and does not measure the consumer value of variety.
- Advertising can provide information or manipulate preferences; its costs and benefits are not displayed.
- Entry may be delayed or limited by leases, platforms, finance, regulation and brand loyalty.
- Firms can differ in cost and quality, so a single representative firm may conceal substantial heterogeneity.
- Long-run tangency is a theoretical endpoint, not a prediction that real markets remain permanently at normal profit.