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Monopolistic Competition in the Long Run

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Economics

People love the Mcdonald's Big Mac, but when they try to order one at Burger King they look at you funny. Burger making is a competitive market, but yet I can't get this type of burger anywhere else which sounds like a monopoly, what's going on here? Perfect competition and monopoly are two main market structures that economists use to analyze the markets. Now, let’s assume a combination of both worlds: Monopolistic Competition. In monopolistic competition, in the long run, each new firm entering the market has an effect on the demand for the firms that are already active in the market. The new firms drive down the profit of competitors, think about how the opening of a Whataburger or Five Guys would affect the Mcdonald's sales in the same area. In this article, we will learn all about the structure of monopolistic competition in the long run. Ready to learn? Let’s start!

The Definition of Monopolistic Competition in the Long Run

Firms in a monopolistic competition sell products that are differentiated from each other. Due to their differentiated products, they have some market power over their products which makes it possible for them to determine their price. On the other hand, they face competition in the market since the number of firms active in the market is high and there are low barriers to entering the market.

Monopolistic competition from short run to long run

A major factor in the short run is that firms can make profits or incur losses in a monopolistic competition. If the market price is above the average total cost at the equilibrium output level, then the firm will make a profit in the short run. If the average total cost is above the market price, then the firm will incur losses in the short run.

Firms should produce a quantity where marginal revenue equals marginal cost to maximize the profit or minimize the losses.

However, the equilibrium level is the major factor in the long run, where firms will earn zero economic profit in a monopolistic competition. The market would not be at equilibrium in the long run if the current firms are making profits.

Monopolistic competition in the long run when at equilibrium is characterized as firms always making zero economic profit. At the equilibrium point, no firm in the industry wants to leave and no potential firm wants to enter the market.

As we assume there is free entry in the market and some firms are making a profit, then new firms want to enter the market as well. The market would be at equilibrium only after the profits will be eliminated with the new firms entering the market.

The firms that are incurring losses are not at equilibrium in the long run. If the firms are losing money, they have to exit the market eventually. The market is only at equilibrium, once the firms that are incurring losses will be eliminated.

Examples of Monopolistic Competition in the Long Run

How do firms that enter the market or the ones that exit the market affect the existing firms in the market? The answer lies in the demand. Although the firms differentiate their products, they are in competition and the number of potential buyers stays the same.

Assume that there is a bakery on your street and the customer group is the people living on that street. If another bakery will open on your street, the demand for the old bakery is likely to decrease given the number of customers is still the same. Even though the products of those bakeries are not exactly the same (also differentiated), they are still pastries and it is less likely that one would shop from two bakeries on the same morning. Therefore, we can say that they are in monopolistic competition and the opening of the new bakery will affect the demand for the old bakery, given the number of customers staying the same.

What happens to the firms in the market if other firms exit? Let's say the first bakery decides to close, then the demand for the second bakery would increase significantly. The customers of the first bakery now have to decide between two options: buying from the second bakery or not buying at all (preparing the breakfast at home for instance). Since we assume a certain amount of demand in the market, it would be very likely that at least some of the customers from the first bakery start to shop from the second bakery. As we see in this bakery example demand for - yummy goods - is the factor that limits how many firms exist in the market.

Demand curve shifts and long Run Monopolistic Competition

Since the entry or exit of the firms will affect the demand curve, it has a direct effect on the existing firms in the market. What does the effect depend on? The effect depends on whether the existing firms are profitable or incurring losses. In Figures 1 and 2, we will look at each case closely.

If the existing firms are profitable, new firms will enter the market. Accordingly, if the existing firms are losing money, some of the firms will exit the market.

If the existing firms are making a profit, then new firms have an incentive to enter the market.

Since the available demand in the market splits among the firms active in the market, with each new firm in the market, the available demand for the firms that already exist in the market decreases. We see this in the bakery example, where the entry of the second bakery decreases the available demand for the first bakery.

In Figure 1 below, we see that the demand curve of the existing firms shifts leftwards (from D1 to D2) since new firms are entering the market. Consequently, the marginal revenue curve of each firm also shifts leftwards (from MR1 to MR2 ).

Entery of Firms in Monopolistic Competition StudySmarter

Figure 1. Entry of Firms in Monopolistic Competition - StudySmarter

Accordingly, as you can see in figure 1, the price will decrease and the overall profit will fall. The new firms stop entering until the firms start making zero profit in the long run.

Zero profit isn't necessarily bad, it's when total costs are equal to total revenue. A firm with zero profit can still pay all its bills.

In a separate scenario, consider, that if the existing firms are incurring a loss, then exit will occur in the market.

Since the available demand in the market splits among the firms active in the market, with each firm exiting the market, the available demand for the remainşng firms in the market increases. We see this in the bakery example, where the exit of the first bakery increases the available demand for the second bakery.

We can see the demand change in this case in Figure 2 below. Since the number of existing firms decreases, there is a rightwards shift (from D1 to D2) in the demand curve of existing firms. Accordingly, their marginal revenue curve is shifted rightwards (from MR1 to MR2).

Exit of Firms in Monopolistic Competition StudySmarterFigure 2. Exit of Firms in Monopolistic Competition - StudySmarter

The firms that do not exit the market will experience increased demand and thus start receiving higher prices for each product and their profit increases (or loss decrease). The firms stop exiting the market until the firms start making zero profit.

Long Run Equilibrium under Monopolistic Competition

The market will be at equilibrium in the long run only if there is no exit or entry in the market anymore. The firms will not exit or enter the market only if every firm makes zero profit. This is the reason why we name this market structure monopolistic competition. In the long run, all firms make zero profit just as we see in perfect competition. At their profit-maximizing output quantities, the firms just manage to cover their costs.

Graphical representation of monopolistic competition in the long run

If the market price is above the average total cost at the equilibrium output level, then the firm will make a profit. If the average total cost is above the market price, then the firm incurs losses. At the zero-profit equilibrium, we should have a situation between both cases, namely, the demand curve and the average total cost curve should touch. This is only the case where the demand curve and the average total cost curve are tangent to each other at the equilibrium output level.

In Figure 3, we can see a firm in monopolistic competition and is making zero profit in the long-run equilibrium. As we see, the equilibrium quantity is defined by the intersection point of the MR and MC curve, namely at A.

 Long Run Equilibrium in Monopolistic Competition StudySmarteFigure 3. Long Run Equilibrium in Monopolistic Competition - StudySmarter

We can also read the corresponding quantity (Q) and the price (P) at the equilibrium output level. At point B, the corresponding point at the equilibrium output level, the demand curve is tangent to the average total cost curve.

If we want to calculate the profit, normally we take the difference between the demand curve and the average total cost and multiply the difference with the equilibrium output. However, the difference is 0 since the curves are tangent. As we expect, the firm is making zero profit in the equilibrium.

Characteristics of Monopolistic Competition in the Long Run

In the long run monopolistic competition, we see that the firms produce a quantity where the MR equals MC. At this point, demand is tangent to the average total cost curve. However, at the lowest point of the average total cost curve, the firm could produce more quantity and minimize the average total cost(Q2) as seen in figure 4 below.

Excess capacity: monopolistic competition in long run

Since the firm produces below its minimum efficient scale - where the average total cost curve is minimized- there is an inefficiency in the market. In such a case, the firm could increase the production but produce more than the capacity in the equilibrium. Thus we say the firm has excess capacity.

Excess Capacity in Monopolistic Competition in Long Run StudySmarterFigure 4. Excess Capacity in Monopolistic Competition in Long Run - StudySmarter

In Figure 4 above, an excess capacity issue is illustrated. The difference that the firms produce(Q1) and the output at which the average total cost is minimized(Q2) is called excess capacity(from Q1 to Q2). Excess capacity is one of the main arguments that is used for the social cost of monopolistic competition. In a way, what we have here is a trade-off between higher average total costs and higher product diversity.

Monopolistic competition, in the long run, is dominated by zero-profit equilibrium, as any deviation from zero profit will cause firms to enter or exit the market. In some markets, there may be excess capacity as a by-product of a monopolistic competitive structure.

Monopolistic Competition in the Long Run - Key Takeaways

  • Monopolistic competition is a type of imperfect competition where we can see characteristics of both perfect competition and monopoly.
  • Firms should produce a quantity where marginal revenue equals marginal cost to maximize the profit or minimize the losses.
  • If the existing firms are making a profit, the new firms will enter the market. Consequently, the demand curve of the existing firms and the marginal revenue curve shift leftwards. The new firms stop entering until the firms start making zero profit in the long run.
  • If the existing firms are incurring a loss, then some firms will exit the market. Consequently, the demand curve of existing firms and their marginal revenue curve shift rightwards. The firms stop exiting the market until the firms start making zero profit.
  • The market will be at equilibrium in the long run only if there is no exit or entry in the market anymore. Thus, all firms make zero profit in the long run.
  • In the long run and at the equilibrium output level, the demand curve is tangent to the average total cost curve.
  • In the long run equilibrium, the firm’s profit-maximizing output is less than the output where the average total cost curve is minimized. This leads to excess capacity.

Monopolistic Competition in the Long Run

The market will be at equilibrium in the long run only if there is no exit or entry in the market anymore. Thus, all firms make zero profit in the long run.

In the long run and at the equilibrium output level, the demand curve is tangent to the average total cost curve.

The market will be at equilibrium in the long run only if there is no exit or entry in the market anymore. Thus, all firms make zero profit in the long run.

Assume that there is a bakery on your street and the customer group is the people living on that street. If another bakery will open on your street, the demand for the old bakery is likely to decrease given the number of customers is still the same. Even though the products of those bakeries are not exactly the same (also differentiated), they are still pastries and it is less likely that one would shop from two bakeries on the same morning. 

The market will be at equilibrium in the long run only if there is no exit or entry in the market anymore. The firms will not exit or enter the market only if every firm makes zero profit. This is the reason why we name this market structure monopolistic competition. In the long run, all firms make zero profit just as we see in perfect competition. At their profit-maximizing output quantities, the firms just manage to cover their costs.

If the existing firms are making a profit, the new firms will enter the market. Consequently, the demand curve of the existing firms shifts leftwards.

If the existing firms are incurring a loss, then some firms will exit the market. Consequently, the demand curve of existing firms shifts rightwards. 

Final Monopolistic Competition in the Long Run Quiz

Question

Which of the following is a characteristic of monopolistic competition?

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Answer

differentiated product

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Question

Which of the following is possible in a monopolistic competition in the long run?

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Answer

positive economic profit

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Question

If the existing firms are making a profit in the short term, the new firms will enter the market until the firms start making zero profit in the long run.

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Answer

True

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Question

If the existing firms are making a profit, the new firms will enter the market and the demand curve of the existing firms shift rightwards.

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Answer

True


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Question

If the existing firms are incurring a loss, then some firms will exit the market and the demand curve of existing firms shift rightwards. 

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Answer

True

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Question

In Monopolistic Competition, all firms make positive profit in the long run.

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Answer

False

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Question

In the long run and at the equilibrium output level, the demand curve is tangent to the average total cost curve.

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Answer

True

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Question

What is the cause of the excess capacity?

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Answer

a firm’s profit-maximizing output is less than the output that the firm could potentially supply

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Question

Which of the following is true for a firm'S demand curve in monopolistic competition?

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Answer

vertical

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Question

If the existing firms are incurring a loss, then some firms will exit the market until when?

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Answer

Until the firms start making zero profit.

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Question

When drawing a monopolistic competition graph in long-run equilibrium, what is the relationship between the demand curve is and the ATC? 

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Answer

ATC is above the demand curve

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Question

Firms should produce a quantity where marginal revenue equals marginal cost to maximize the profit or minimize the losses.

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Answer

True

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Question

If the demand curve shifts rightwards, how does the marginal revenue move?



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Answer

The marginal revenue shifts rightwards. 

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Question

Why do the firms that are entering the market affect the existing firms in the market?

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Answer

Because of the change in demand

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Question

 If the existing firms are profitable, new firms will enter the market. Accordingly, if the existing firms are losing money, some of the firms will exit the market.

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Answer

True

Show question

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