Question

Explain why monopolistically competitive firms are considered to be less efficient than the perfectly competitive ones in the long run despite the fact that both are operating at the break-even points.

Answer 1

The long-term result of entry and exit in a perfectly competitive market is that all firms end up selling at the price level determined by the lowest point on the average cost curve. This outcome is why perfect competition displays productive efficiency: goods are being produced at the lowest possible average cost. However, in monopolistic competition, the end result of entry and exit is that firms end up with a price that lies on the downward-sloping portion of the average cost curve, not at the very bottom of the AC curve. Thus, monopolistic competition will not be productively efficient.

In a perfectly competitive market, each firm produces at a quantity where price is set equal to marginal cost, both in the short run and in the long run. This outcome is why perfect competition displays allocative efficiency (P = MR = MC). In a monopolistically competitive market, the rule for maximizing profit is to set MR = MC—and price is higher than marginal revenue, not equal to it because the demand curve is downward sloping. When P > MC, which is the outcome in a monopolistically competitive market, the benefits to society of providing additional quantity, as measured by the price that people are willing to pay, exceed the marginal costs to society of producing those units. A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry.