Question

Answer the following questions comparing monopolistic competition to perfect competition.

a. In the long run, how does the profit earned by a firm operating in a monopolistically competitive market compare to the profit the same firm would earn if it were instead operating in a perfectly competitive market? Please explain.

b. In the long run, how does the average cost of production for a firm operating in a monopolistically competitive market compare to the average cost of production for the same firm if it were instead operating in a competitive market? Please explain.

Answer 1

The basic and most fundamental difference between a monopolistic firm and a perfectly competitive firm is that monopolistic firm faces no competition while the perfectly competitive firm has many competitors and it is a price taking firm while monopolistic firm chooses its own price.

a. In the long run monopolistically operating firm chooses its price such that its maximizes the total profit of the monopolist. And the profit maximizing condition of a monopolist is given by

MR = MC

Where MR =marginal revenue

MC = Marginal cost

So in the long run monopolistically operating firm maximizes its profits.

Now let's come to the perfectly competitive market. The perfectly competitive market is characterized by having large number of sellers and buyers with identical products with free entry and exit of firms. And in the long run perfectly competitive market price is always equal to ATC = MC such that firms earns zero profit.

Here MC = marginal cost

ATC = average total cost

So in the long run if the monopolistically operating firm were to operate in perfectly competitive market then it would earn a zero profit. This is a direct consequence of free entry and exit of firms, since whener there are positive profits new firms enters in the market and competition increases and prices decreases. And this keeps on going until price becomes equal to ATC such that there are no more positive profits and no new firms enter the market.

So a monopolistically operating firm earns a positive profit in the long run run while the same firm would earn zero profit in the perfectly competitive market framework.

b.

As discussed earlier the monopolistically operating firm looks to maximize its profit and only cares about its marginal revenue and marginal cost. And since the monopolist has a downwards sloping demand curve which means to sell higher amount of quantities it will have to lower its price.

So in the long run the monopolist will operate at a part where the long run marginal cost is equal to marginal cost of production and AC is still falling.

And the perfectly competitive firm in the long run will operate at the point on average cost where it is minimum and at the minimum of average cost is equal to marginal cost. This is due to the fact that demand curve for the perfect competitive firm has perfectly elastic demand curve and it can sell any quantity at the same price, so firms looks to minimize their average cost of production and they produce the quantity at which the average cost of production is minimized.