Monopolistic competition does not efficiently allocate resources. The reason for this inefficiency is found with market control and negatively-sloped demand curve. The negative slope means that the price charged by the monopolistically competitive firm is greater than marginal revenue. As a profit-maximizing firm that equates marginal revenue with marginal cost, the price charged by monopolistic competition is also greater than marginal cost. The inequality between price and marginal cost is what makes monopolistic competition inefficient.
Because price exceeds marginal cost, the economy gives up less satisfaction from other goods not produced than it receives from the good that is produced. The economy can gain satisfaction by producing more of the good.
However, in the grand scheme of things, monopolistic competition is not the worst offender when it comes to efficiency. Because the demand curve facing a monopolistically competitive firm (with minimal market control) tends to be relative elastic, the difference between price and marginal revenue is relatively small. This means that the difference between price and marginal cost, and the degree of inefficiency, is also relatively small.
Inefficient Profit Maximization
Consider the production and sale of Deluxe Club Sandwiches, a tasty luncheon meal produced for the residents of Shady Valley by the hypothetical monopolistically competitive firm, Manny Mustard's House of Sandwich.
A typical profit-maximizing output determination using the marginal revenue and marginal cost approach is presented in this diagram. Manny maximizes profit by producing output that equates marginal revenue and marginal cost, which is 6 sandwiches. The corresponding price charged is $4.95.
This profit-maximizing production is not efficient. In particular, the price is $4.95, but the marginal cost is only $4.65. Society is producing and consuming a good that it values at $4.95 (the price). However, in so doing, society is using resources that could have produced other goods valued at $4.65 (the marginal OPPORTUNITY cost). Society gives up $4.65 worth of value and receives $4.95.
This is a good thing. It is so good, that society should do more. However, the monopolistically competitive firm is not letting this happen. Manny is not devoting as many resources to the production of Deluxe Club Sandwiches as society would like.
An Efficient AlternativeThe degree of monopolistic competition inefficiency can be illustrated with a comparison to perfect competition. Such a comparison is easily accomplished by clicking the [Perfect Competition] button in the exhibit above. A primary use of perfect competition is to provide a benchmark for the comparison with other market structures, such as monopolistic competition.
A comparison between monopolistic competition and perfect competition indicates:
Monopolistic competition is clearly inefficient. However, in the big scheme of all things inefficient, this is not a particularly series case of inefficiency. Yes, the price is higher and the quantity is less. Yes, marginal cost is less than price. But, a difference of $0.02 between the perfect competition price and the monopolistic competition price does not seem to be excessive. And, it could be a whole lot worse with another market structure such as monopoly.
- Monopolistic competition produces less output than perfect competition. In this example, monopolistic competition produces 6 sandwiches compared to slightly more than 6 sandwiches for perfect competition. Manny is not allocating enough resources to the production of Deluxe Club Sandwiches.
- Monopolistic competition charges a higher price than perfect competition. In this example, the monopolistically competitive price is $4.95 versus about $4.93 for perfect competition. Manny is NOT efficient because he produces a quantity in which price is greater than marginal cost.
While an evaluation of the relative good or bad of inefficiency is a value judgement falling in the realm of normative economics, such a judgement is worth considering. The reason is that inefficiency in the real world is a matter of degree. Some inefficiency is really severe and some is not. Considering the fifth rule of imperfection that nothing is perfect and never will be, it is important to consider the degree of inefficiency when interest turns to remedial actions, that is, economic policies and government intervention.
While a monopoly that charges a $10 price while incurring a marginal cost of $2 creates a serious inefficiency problem that probably warrants government intervention, a monopolistically competitive firm that charges a $4.95 price while incurring a marginal cost of $4.65, might not.
Consider that government policies fall victim to the fifth rule of imperfection, too. Any corrective action by government might actually worsen efficiency rather than achieving it. While government "probably" would not do worse than a really bad monopoly, it is very likely to do worse than a not-so-bad monopolistically competitive firm.
MONOPOLISTIC COMPETITION, EFFICIENCY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: June 20, 2018].