Question

 4. Is monopolistic competition efficient?

 Suppose that a firm produces baseball bats in a monopolistically competitive market. The following graph shows its demand curve, marginal revenue (MR) curve, marginal cost (MC) curve, and average total cost (ATC) curve.

 Place a black point (plus symbol) on the graph to indicate the long-run monopolistically competitive equilibrium price and quantity for this firm. Next, place a grey point (star symbol) to indicate the minimum average total cost the firm faces and the quantity associated with that cost.

 Because this market is a monopolistically competitive market, you can tell that it is in long-run equilibrium by the fact that _______  at the

 optimal quantity for each firm. Furthermore, the quantity the firm produces in long-run equilibrium is _______  the efficient scale.

 True or False: This indicates that there is excess capacity in the market for bats.

 True

 False

 Monopolistic competition may also be socially inefficient because there are too many or too few firms in the market. The presence of the _______  externality implies that there is too little entry of new firms in the market.

Answer 1

At long run equilibrium under monopolistically competitive market structure,demand curve is tangent to average total cost (ATC). Marginal cost, MC, curve intersects the average total cost curve at its minimum. Clearly, we can see where the MC curve intersects ATC curve. Correspondingly, the required points are marked in the following graph:

Optimal quantity for each firm under monopolistically competitive market occurs where the marginal cost equals marginal revenue. From the graph, we can see that the MC and MR curves intersect at quantity level of 30 units. Further, note that 30 units is the long run equilibrium quantity as well (as denoted by the black star in the graph above).

At this point, since demand curve is tangent to the ATC curve, it means that profit is 0. Let's see how:

Since demand curve tangent to ATC curve, Price = ATC (as demand curve mark points of price and quantity demanded). On multiplying both sides by quantity Q, P*Q = ATC*Q

Total revenue = total cost, implying the breakeven or zero profit point.

So, correct option should be profits are 0 (however, list of options could be helpful here)

Efficient scale is reached where the minimum average cost is achieved. From the graph, we can see that this is indicated by the grey star, implying a quantity level of 60 units. We saw above that in reality, firms are producing at 30 units, so, the quantity firm produces in long run equilibrium is less than the efficient scale (30 < 60).

Excess capacity refers to a situation where a firm is producing at a quantity level lower than at what level it should produce. Since, minimum average cost is reached when it equals MC, and MC cuts ATC curve from below, it means that if MC is less than the ATC at production when there is excess capacity, as more can still be produced to reach efficient scale.

We have already seen that firms are producing below the efficient scale point, indicating a situation of excess capacity. So, the given statement is indeed True.

The number of firms in the market is too little as more firms could enter and production could still be increased till the minimum efficient scale is reached. Currently, in long run, production is too little, still leaving a scope for lower per unit cost as the output production is increased. Positive externality implies too little entry of new firms in the market.