Question

Describe and illustrate the difference between perfect competition and monopolistic competition in the long run. Comment on long run profit, price sensitivities that firms are responding to as well as welfare and efficiency outcomes in both cases.

Answer 1

Ans) Perfectly competitive market is where there are many sellers selling homogeneous products. There is no barrier to entry and exit. Firms are price takers. And price is equal to marginal revenue which also acts as a demand curve for an individual firm. A profit maximising firm produces the quantity where MR and MC curve intersect.

Monopolistic competition is where there are many sellers selling homogeneous but differentiated products. Due to differentiation, firms are not price takers. It faces downward sloping demand curve and marginal revenue curve lies below the demand curve. A profit maximising firm produces the quantity where MR and MC curve intersect and then uses demand curve to determine the price.

In long run due to ease of entry and exit, both Perfectly competitive and monopolistic firm earns zero economic profit. That is price is equal to ATC.

But the long run is different for both the firms.

In Perfectly competitive market, in long run, price is equal to minimum of ATC where firms earn zero economic profit and both productive and allocative efficiency is achieved. And firm produces socially optimal quantity so there is no deadweightloss.

But in monopolistic firm, though the long run price is equal to ATC but it is not equal to minimum of ATC. And price charged is above the marginal cost. Therefore it does not achieve productive or allocative efficiency in long run. Since it does not produce socially optimal quantity in long run, there is deadweightloss. Further the difference between socially optimal quantity and quantity produced is known as excess capacity.

Lastly, the elasticity of demand is very high in long run in monopolistic competition due to presence of large number of firms and hence firms are very much price sensitive. So, they decrease or increase their price in long run depending upon the profits.

In Perfectly competitive market,for an individual firm, demand is Perfectly elastic and producer respond to it by increasing or decreasing the production.