Efficiency in Monopolistic Competition: Study with Video Lessons, Practice Problems & Examples

In monopolistic competition, firms fail to achieve productive efficiency, as they do not produce at the minimum of the average total cost (ATC) due to excess capacity. They also lack allocative efficiency, where marginal benefit (demand) does not equal marginal cost. Instead, firms maximize profit where marginal revenue equals marginal cost, leading to a lower quantity produced than the socially efficient level. This results in deadweight loss, indicating that consumer preferences are not fully met, highlighting the inefficiencies inherent in this market structure.

Monopolistic Competition Productive Efficiency

All right, now let's consider the topics of productive efficiency and allocative efficiency in monopolistic competition. So what we're going to see is that monopolistically competitive firms do not achieve productive or allocative efficiency, okay? They're not going to achieve either of them. In perfect competition, we saw that both productive and allocative efficiency were reached. So remember, productive efficiency is producing at the lowest possible cost, okay, and as we've discussed, the condition for productive efficiency is something like price equaling average total cost, right? The minimum of the average total cost. Let me put minimum here. Okay? So the lowest possible cost like we just said is that minimum of the average total cost curve, right? And as we saw when we were talking about the long run, right, they don't ever reach the minimum of the average total cost curve because they have that excess capacity. They have the downward sloping demand curve that can only reach average total cost on the downward sloping part of the average total cost. Right? That's the only place it could be tandem. So let's look at an example here from perfect competition. This is what it looked like, right? We had a firm with this price that was average revenue equals marginal revenue in perfect competition, right? That was the special case where price equals average revenue and marginal revenue. Well, in the long run, we reached the situation where marginal revenue equals marginal cost and it's also the minimum of the ATC, right? This was the quantity we would produce there and that's at the minimum of our average total cost, so that's how we were productively efficient in perfect competition, but over here in monopolistic competition, so I'm going to scroll up, so I'm not in the way. Monopolistic competition, well, what happened? In the long run, we reached this 0 profit point, right, where price equals average total cost, but so right here marginal revenue equals marginal cost profit maximizing quantity, right? We've got that quantity, but if we go up to our demand curve and average total cost curve, right, we're not at the minimum of the average total cost. You can see that average total cost continues decreasing after that, right? That next portion is still decreasing. So since we're not at that minimum of average total cost, we're not being as efficient as possible, right? If we were producing a few more units, we would get more economies of scale and have a lower average total cost, so that's not what's happening. We're not being productively efficient, okay? So what do we see? In the long run, perfect competition forces firms to produce at minimum ATC, but in the long run, monopolistic competition firms produce at a quantity before the minimum ATC, right? So minimum ATC, if we go back up to our graph here, on the right graph, our minimum ATC was somewhere out here, right? So this quantity out here would have been where a perfectly competitive firm, quantity in perfect competition, right? The efficient quantity where in our case, the monopolistic competition MC is producing less than that, right? Less than that efficient quantity. Cool? So let's stop here and in the next video, let's discuss allocative efficiency in monopolistic competition.

Monopolistic Competition Allocative Efficiency

Alright. So now let's discuss the idea of allocative efficiency, and remember that allocative efficiency is the idea that production represents our consumer preferences, right? What the consumers want is what is being produced, and we're producing the right amount for our consumers. We see that our condition here is where the marginal benefit to the consumers equals the marginal cost to producers. So we're going to produce up to the point where marginal benefit equals marginal cost, and that is where we have allocative efficiency.

Let's see how we're not reaching allocative efficiency. First, let's think about the marginal benefit. The marginal benefit is represented by the demand curve, right? That's the benefits that the consumers receive. And the marginal cost comes from our marginal cost curve. We have a marginal cost curve on the graph, and that's where that comes from, but firms produce where marginal revenue equals marginal cost, right? Marginal revenue equals marginal cost; that's profit-maximizing, and that's what they're concerned with. They want to maximize their profit, but that is not where the marginal cost and demand curve intersect. If we were going to find the allocative efficiency point, that would be where the demand curve intersects the marginal cost curve. This is the marginal benefit; this is the marginal cost; those would be allocative efficiency where those cross, and if we go back up to our graph here, we're not producing at this quantity, right, where the demand and marginal cost are equal. This point right here where the demand and marginal cost are equal would be the allocatively efficient quantity, right? And we're not producing there; we're producing some lower quantity to increase our profit.

That is why we're not being allocatively efficient. The marginal benefits to the demand curve. That's the marginal benefit to the consumer. Here on the demand curve. That's the marginal benefit to the consumer, and the marginal cost to the producer is down here. You can see that the marginal benefit is greater than the marginal cost at that point, so we should have produced more units if we were being socially efficient there.

That is why we don't reach productive nor allocative efficiency in monopolistic competition. So let's go ahead and move on to the next video.

The loss of efficiency that occurs in monopolistic competition has to be weighed against the gain of

• A. An increase in employment
• B. Higher wages for employees
• C. Greater product variety
• D. Reduced environmental damage

Here’s what students ask on this topic:

What is productive efficiency in monopolistic competition?

Productive efficiency occurs when firms produce at the lowest possible cost, which is at the minimum of the average total cost (ATC) curve. In monopolistic competition, firms do not achieve productive efficiency because they produce at a quantity where the ATC is not minimized. This is due to excess capacity, meaning firms operate on the downward-sloping part of the ATC curve rather than at its minimum. As a result, they do not fully exploit economies of scale, leading to higher average costs compared to perfectly competitive markets.

Why do firms in monopolistic competition fail to achieve allocative efficiency?

Allocative efficiency is achieved when the quantity of goods produced represents consumer preferences, which occurs where marginal benefit (demand) equals marginal cost. In monopolistic competition, firms maximize profit where marginal revenue equals marginal cost, not where marginal benefit equals marginal cost. This results in a lower quantity produced than the socially efficient level, leading to a deadweight loss. Consequently, consumer preferences are not fully met, and the market fails to allocate resources efficiently.

How does excess capacity affect firms in monopolistic competition?

Excess capacity in monopolistic competition means that firms produce at a level below the minimum of the average total cost (ATC) curve. This occurs because firms face a downward-sloping demand curve and cannot produce at the minimum ATC due to the nature of their market structure. As a result, they do not fully utilize their production capabilities, leading to higher average costs and inefficiencies compared to perfectly competitive firms that produce at the minimum ATC.

What is the difference between productive and allocative efficiency in monopolistic competition?

Productive efficiency refers to producing goods at the lowest possible cost, which occurs at the minimum of the average total cost (ATC) curve. In monopolistic competition, firms do not achieve this due to excess capacity. Allocative efficiency, on the other hand, occurs when the quantity of goods produced matches consumer preferences, where marginal benefit equals marginal cost. Firms in monopolistic competition fail to achieve allocative efficiency because they produce where marginal revenue equals marginal cost, not where marginal benefit equals marginal cost, leading to a lower quantity produced than the socially efficient level.

What is deadweight loss in the context of monopolistic competition?

Deadweight loss in monopolistic competition refers to the loss of economic efficiency when the equilibrium quantity of goods produced is less than the socially optimal quantity. This occurs because firms maximize profit where marginal revenue equals marginal cost, rather than where marginal benefit (demand) equals marginal cost. As a result, the quantity produced is lower than the allocatively efficient level, leading to unmet consumer preferences and a loss of potential welfare in the market.