Monopolistic Competition in the Long Run: Study with Video Lessons, Practice Problems & Examples

In monopolistic competition, firms experience zero economic profit in the long run as price equals average total cost. Unlike perfect competition, firms do not produce at minimum average total cost, leading to excess capacity. To maintain profitability, firms must continuously differentiate their products, adapting to market changes and consumer preferences. This dynamic ensures they remain competitive despite the entry of new firms, which increases substitutes and makes demand more elastic. The equilibrium is reached when marginal revenue equals marginal cost, resulting in no economic profit.

Monopolistic Competition in the Long Run

Now let's consider what happens in the long run for monopolistic competition. So remember when we discussed the long run for perfect competition, we saw that there was no economic profit, right? The price equaled average total cost in the long run. Well guess what? In monopolistic competition, the same thing happens. Price is going to equal average total cost, alright? But it's going to be a little different, so let's see how it is. So as with perfect competition, the entry and exit of competitors lead to 0 economic profit in the long run, okay? So you can imagine, just like we said with perfect competition, when there's profits being made, other people are going to join the action, right? They're going to see that there's money and they want to get in on it, right? So we're going to be in some situation like we see in this left graph where we've got short run profits. Okay? We've got a demand curve, our marginal revenue, we've got marginal cost, and average total cost. What we're going to see in the short run, right, we want to produce where marginal revenue equals marginal cost, right? That's right here. This quantity and at that quantity, what's our price and average total cost? Well, let's go up from there and let's find those curves. So here's average total cost. Let's keep going up and here is the price on the demand curve, right? So our price, our average total cost, and this area in here is our profit, right? This is the profit that the firm is making and that profit leads other firms to say hey, we should get in there and start making some money, right? So as we saw with perfect competition, firms are going to keep entering until those profits disappear, alright? So what we're going to see here in monopolistic competition that's a little different before we get to the graph, look underneath here on our first bullet point. So what's going to happen is the entry of firms, right, when we have profits, other firms are going to come in, so say we're a sandwich shop And we're making money and now other firms want to get in and start making sandwiches as well. So these entry of firms is going to increase the availability of substitutes, right? There's going to be other, substitute substitutes. There's going to be other sandwich shops offering similar goods, right? And what's going to happen? Well, some of the firm's customers are going to go to the new firm, right? So they're going to go try that other sandwich shop and they're going to say hey, this place is way better, I'm going to come here instead. This is going to be my new regular option, so that's going to shift our demand to the left, right? Because we lost some of our customers, the demand shifted to the left. They prefer the other product now, but it's also going to make our customers more sensitive to our price changes, right? So you can imagine now that there's more options to them, they might say, hey, you increased your price by a dollar, you know, I was willing to pay $5 for your sandwich, but $6 I'm just going to go somewhere else and get a sandwich instead, right? That means that our demand has become right behind me it says elastic, it became more elastic, right? The demand becomes more elastic as well, so it shifted to the left and it also becomes more elastic, alright? And that's what we see back here on the graph, okay? Notice that on the graph here, our demand curve has shifted both to the left, right, from our short run model on the in the left graph to the right hand graph for the long run, our demand shifted to the left as well as it became more elastic, right? It's sloped like this a little more and that's going to keep happening until we reach a point where price equals average total cost, right? Just like we saw in perfect competition, price equals average total cost and when price equals average total cost, think about our profit equation, right? Our profit equation was P - ATC∗ Q, right? Well, if they're equal to each other, if the price is $5 and the average total cost is $5, there's no profit, right? So when price equals average total cost, we have no profit and that's what we see here, right? If we go to our profit-maximizing point where marginal revenue equals marginal cost, this quantity right here well, check out what's happening on our curves here. Our demand curve, our price, and our average total cost are equal to each other, right? Price equals average total cost right there. Price equals average total cost, so there's no profit, right? But this is a little different than what we saw in perfect competition. So in perfect competition, if you'll recall, the long run equilibrium was at the minimum of average total cost, right? In perfect competition, we had some sort of price level which was the demand to the firm that would have looked something like this, right? I'm going to draw it in real quick. It would have looked something like this, right? And it would have touched at the bottom of the average total cost curve, right? And that's only possible in perfect competition because we had a flat at at just one point and be able to touch the minimum point, right? So remember, when we talk about touching at just one point, that's like a tangent. A tangent line is what we usually call it in mathematics where the lines are touching only at one point. So what we see here with our on our regular graph with our demand and our average total cost, right, that point where our price equals average total cost that we've marked, that's only happening at one point, right? The demand curves coming in and they touch at one point and then they separate again. Same thing happens in perfect competition with that minimum ATC, right? What I had just drawn in there, at this minimum ATC in perfect competition, right, that's where they touch, but imagine how that could be possible with a downward sloping demand curve. There's no way for a downward sloping demand curve like something like this touching the bottom to only touch it at one point, right? It kind of looks like it's only touching at one point there, but if we were to extend our average total cost curve, right, if this keeps going, right, we're only showing a portion of it, if we let it keep going, these are going to touch again right here, right? So there's going to be another point they touch. They're not tangent, okay? So remember, we need that tangent condition when we draw in our demand curve and that's where we reach our long run equilibrium where price equals average total cost, right? Right here where we have no profit, but we're not at our minimum average total cost, okay? So we still have a point where price equals average total cost, but it's not the minimum. So what implications does that have? Alright, let's look down here in that second bullet point. We see that in the long run, the firms do not produce at minimum cost, right? They do not produce at the minimum cost, right? Minimum cost would be the minimum of the ATC curve, right? That is the minimum cost. So only a firm facing a horizontal demand curve just like we saw something like in perfect competition, I'm going to put perf comp for perfect competition, that's the only one that can achieve that minimum ATC, right? Because they're the only one that can get underneath that ATC curve to touch it on the very bottom. Anytime we have this downward sloping demand curve, it's going to have to touch it on that downward part of the average total cost curve, okay? So what does that mean? Well that means we have this idea of excess capacity. Excess capacity, right? The firm is not reaching its minimum average total cost. They're producing at some point before that, right? So they if they were able to expand their production, they would actually reduce their cost and that's a good thing for society, but they're trying to maximize their profit, not reduce their cost, right? They want the maximum amount of profit and that's going to come up at that point where marginal revenue equals marginal cost and that's always going to lead us to have some point where we have excess capacity and that excess capacity what I mean is from our quantity we're producing, this profit-maximizing quantity. I'm going to put PM for profit maximizing and right here, right, this might be the minimum of the ATC. Well, this is the perfect competition quantity, right? That's the efficient quantity where we reach the minimum of the ATC, so you could imagine that everything in between here is our excess capacity. Right? Okay, so that's one condition with the monopolistic competition is that we don't reach that minimum ATC, so we have excess capacity. Okay, so what did we learn here? We learned that those profits are eliminated in the long run. Even though you can make short run profit, the entry and exit of other firms, entry if there's profit, exit if there's losses, is always going to lead us to a situation where the price equals average total cost in the long run, okay? And the other thing there with the excess capacity that is because we're not at our minimum ATC. Cool? Let's go ahead and do some practice and we'll move on in the next video.

How Companies Stay Profitable

Alright. I just want to make one more quick point before we move on with monopolistic competition. So we saw in the long run there's no economic profit to be made, right? So you might think, why do these firms stay in business or how has a firm like McDonald's or Starbucks stayed relevant and stayed profitable, right? Well, the trick is that they have to constantly differentiate their product, right? If they were not to keep differentiating their product, they would reach a point where other firms are eating up all their profits and they're not making a profit anymore. So think about Starbucks, when they first breached the market they were making tons of money selling premium coffee, right? And then other firms started coming in. I know even here in Miami, I see other coffee shops that are exactly the same. They set up with the same little deli, they've got in the front with the little sandwiches, they've got the same choices of coffee, iced coffees, frappuccino-type things, right? They've set up that same business. So then what did Starbucks do? Well, they started selling other products as well, right? They started selling tea, they started selling coffee mugs, they started a loyalty club, right? They started all these different things to differentiate their product and keep themselves making a profit, right? So the trick here is to keep differentiating your product to keep you in that short run profitable state, right? If you become idle at one point, other firms are just going to come in, replicate what you're doing, and eat up all your profit, alright? So that's just a quick point of how firms do end up staying profitable in the long run, alright? Let's go ahead and move on to the next topic.

New firms will enter a monopolistically competitive market if

• A. Marginal revenue is greater than marginal cost
• B. Marginal revenue is greater than average total cost
• C. Price is greater than marginal cost
• D. Price is greater than average total cost

What is true of a monopolistically competitive market in long-run equilibrium?

• A. Price is greater than marginal cost
• B. Price is equal to marginal revenue
• C. Firms make positive economic profits
• D. Firms produce at the minimum of average total cost

Here’s what students ask on this topic:

What happens to economic profit in the long run under monopolistic competition?

In the long run, firms in monopolistic competition experience zero economic profit. This occurs because the entry of new firms into the market increases the availability of substitutes, which shifts the demand curve to the left and makes it more elastic. As a result, the price eventually equals the average total cost (ATC). When price equals ATC, economic profit is zero, as profit is calculated as (P - ATC) * Q, where P is price, ATC is average total cost, and Q is quantity. Therefore, firms only cover their costs, including normal profit, but do not earn any additional economic profit.

Why do firms in monopolistic competition not produce at minimum average total cost in the long run?

Firms in monopolistic competition do not produce at minimum average total cost (ATC) in the long run due to the downward-sloping demand curve they face. Unlike perfect competition, where firms face a horizontal demand curve and can produce at the minimum ATC, monopolistic competition firms face a downward-sloping demand curve, which intersects the ATC curve at a point above its minimum. This results in excess capacity, meaning firms produce less than the quantity that would minimize their ATC. Consequently, they do not achieve the lowest possible cost of production, leading to inefficiencies in the market.

How do firms in monopolistic competition maintain profitability in the long run?

Firms in monopolistic competition maintain profitability in the long run by continuously differentiating their products. Product differentiation can include variations in quality, features, branding, customer service, and other attributes that make their products stand out from competitors. By doing so, firms can create a loyal customer base and reduce the substitutability of their products, allowing them to charge higher prices and maintain short-run profits. Without ongoing differentiation, new entrants would replicate their offerings, increasing competition and driving economic profits to zero.

What is excess capacity in the context of monopolistic competition?

Excess capacity in monopolistic competition refers to the situation where firms produce at a level of output that is less than the quantity that would minimize their average total cost (ATC). This occurs because the downward-sloping demand curve intersects the ATC curve at a point above its minimum. As a result, firms operate with unused productive capacity, meaning they could produce more at a lower cost per unit but choose not to because it would not maximize their profit. This inefficiency is a characteristic of monopolistic competition and contrasts with perfect competition, where firms produce at the minimum ATC.

How does the entry of new firms affect the demand curve in monopolistic competition?

The entry of new firms in monopolistic competition increases the availability of substitutes, which affects the demand curve for existing firms. As new firms enter the market, some customers of existing firms switch to the new entrants, causing the demand curve for existing firms to shift to the left. Additionally, the increased number of substitutes makes consumers more sensitive to price changes, increasing the elasticity of demand. This means that the demand curve becomes flatter, indicating that a small change in price will result in a larger change in the quantity demanded. These changes continue until economic profit is eliminated in the long run.