Question

Compare graphically the welfare implications of the long run equilibrium of a monopolistically competitive industry, monopoly and a perfectly competitive industry.

Answer 1

Perfect competition: In case of perfect competition there are infinitely many firms and many buyers. Hence, the firms take the market price determined at the market level based on demand and supply. In the long run, a competitive firm always operate at a level where price equals marginal cost. If price > MC, more firms will enter the indudtry till price equals MC. Underlying point is that, long run equilibrium requires price = MC. As a result, the social welfare is maximum in case of perfect competitive equilibrium. As observed from the diagram below, Qc is the longrun equilibrium output where MC = MR = AR and Pc is the competitive price determined based on market demand and supply. Since, price = MC = AC = MR, there is no economic profit for the forms.

Monopolistically competitive firm: In the long run, the firms adjust their cost such that the average cost equals the price. If price > average cost, there is scope for new entrance. Hence, in the longrun the industry is in equilibrium when price equals average cost. As shown in the diagram below, Qm is the monopolistically competitive longrun equilibrium output level and Pm is the equilibrium price, which is also equal to average cost, corresponding the to profit maximizing condition MR = MC. We can also observe the presence of excess capacity in this case since Qm < Qc, i.e., resources are under utiliized. Hence, the welfare is less as compared to perfect competitive equilibrium. Since, price = average cost, there is no economic profit for the firm.

On the other hand, in case of pure monopoly, a firm may stll operate at a level where price > average cost which may generate economic peofit. Correspnding to the profit maximizing condition (MR = MC), the average cost curve may lie below the market demand curve. In this case too, welfare is lower as compared to perfect competitive case. Also, it is less than or equal to as compared to monopolistically competitive case. If monopolist gets a positive economic surplus, the welfare is less than the monopolistically competitive case too.