A monopolistically competitive industry achieves long-run equilibrium through the adjustment of the market price, the number of firms in the industry, and the scale of production of each firm. These adjustments mean that each firm produces at a point of tangency between its negatively-sloped average revenue (demand) curve and its long-run average cost curve. This occurs in the economies of scale portion of the long-run average cost curve. With this production two equilibrium conditions are achieved:
The first condition, marginal revenue (MR) equal to marginal cost (MC and LRMC), means that each firm maximizes profit and has no reason to adjust its quantity of output or plant size. The second condition, price (P) equal to average cost (ATC and LRAC), means that each firm in the industry is earning only a normal profit. Economic profit is zero and there is no economic loss.
|MR = MC = LRMC |
|P = AR = ATC = LRAC |
These two equilibrium conditions can be divided into the six specific conditions: (1) economic inefficiency (P > MC), (2) profit maximization (MR = MC), (3) market control (P = AR > MR), (4) breakeven output (P = AR = ATC), (5) excess capacity (ATC > MC), and (6) economies of scale (LRAC > LRMC).
For a closer look at these six conditions, consider the hypothetical monopolistically competitive Shady Valley restaurant industry. The hypothetical Shady Valley restaurant industry contains a large number of relatively small firms (thousands of meal makers, each producing a handful of meals each day), similar but not identical products (each produces food, but the meals differ from restaurant to restaurant), relative ease of entry and exit (anyone can set up a restaurant with little or no upfront cost and few legal restrictions), and extensive knowledge of prices and technology (ever restaurant knows how to prepare meals and they are aware of relevant prices).
Economic InefficiencyThe condition that price is greater marginal cost (P = MC) means that production does NOT achieve economic efficiency. This means that resources are not being used to produce goods that generate the greatest possible level of satisfaction.
If the price that a hypothetical restauranteer named Manny (as well as ever other monopolistically competitive restauranteer) receives for his meals is greater than the marginal cost of producing a luncheon meal such as sandwiches, then it is possible to produce more sandwiches and improve society's overall satisfaction.
Suppose, for example, that in long-run equilibrium the sandwich price is $4.95 but the marginal cost of sandwich production is $4.65.
Inefficiency exists because the value of the good produced is greater than the value of the good NOT produced. As such, it is possible to increase total satisfaction by producing more sandwiches and fewer macrame plant holders.
- From the buyers viewpoint, this $4.95 price means that they receive $4.95 worth of satisfaction from consuming a sandwich. If buyers did not enjoy $4.95 worth of satisfaction, then they are not willing to pay $4.95. As such, the good produced by the monopolistically competitive restauranteers (that would be sandwiches) generates $4.95 of satisfaction.
- From the sellers viewpoint, the marginal cost is the opportunity cost of producing sandwiches. This is the value of other goods NOT produced when resources are used to produce sandwiches. If the marginal cost of producing a sandwich is $4.65, then the resources that Manny uses to produce sandwiches could have been used to produce another good, such as macrame plant holders or paperback books. And the value of the other good NOT produced is $4.65. In other words, macrame plant holder buyers are willing to pay $4.65 for the macrame plant holders that could have been produced with the resources used to produce the sandwich.
The only way to achieve economic efficiency is to satisfy the condition (P = MC). This condition is NOT satisfied by a monopolistically competitive industry in the long run.
Profit MaximizationThe condition that marginal revenue equals marginal cost (MR = MC) is the standard condition for profit-maximization by a firm. This condition means that, given existing price and cost conditions, a firm is producing the quantity of output that generates the highest possible level of economic profit.
Manny the hypothetical restauranteer maximizes his economic profit by producing the quantity of meals that equates the marginal revenue received for selling meals ($4.65) with the marginal cost of producing meals (also $4.65). It is not possible for Manny to generate any greater economic profit by producing more or fewer meals.
Marginal revenue is the extra revenue that Manny receives for producing meals. Marginal cost is the extra cost Manny incurs when producing meals. When the production of a sandwich changes revenue by exactly the same as it changes cost, economic profit does not change, profit has reached its maximum.
To see why, consider how profit is affected if marginal revenue and marginal cost are NOT equal.
Only by satisfying the condition (MR = MC) is profit maximized. This condition is satisfied by a monopolistically competitive firm in the long run.
- Suppose, for example, that marginal revenue (at $4.65) is greater than marginal cost (only $3.65). When Manny receives $4.65 for producing an extra sandwich that incurs a cost of only $3.65, then his economic profit rises by $1. Any time Manny can sell sandwiches for more than the cost, profit goes up. But if profit can be increased by producing and selling more sandwiches, it must not be maximized.
- Alternatively, suppose that marginal revenue (at $4.65) is less than marginal cost ($5.65). When Manny receives $4.65 for producing an extra sandwich that incurs a cost of $5.65, then his economic profit falls by $1. Any time Manny sells sandwiches for less than the cost, profit goes down. But if profit goes down by producing MORE, it goes up by producing LESS. And if profit can be changed by changing production, it must not be maximized.
Monopolistic CompetitionThe condition that price equals average revenue but is greater than marginal revenue (P = AR > MR) is the standard condition for a monopolistically competitive firm. This condition means that a firm is a price maker with some degree of market control and faces a negatively-sloped demand curve.
The key to this condition is that a monopolistically competitive firm has some market control. The firm does not merely accept the going market price. It can increase the quantity sold by lowering the price.
Manny, for example, can sell his sandwiches for $4.95 each. If he wants to sell more sandwiches, then he must lower the price. If he raises his price, then he sells fewer sandwiches.
This condition also means that the price Manny charges is his average revenue. In fact, average revenue and price are really just two terms for the same thing. Average revenue is the revenue Manny receives per sandwich. Price is the revenue Manny receives per sandwich. Price is almost always equal to average revenue for any firm regardless of market structure.
Monopolistic competition, however, is indicated because marginal revenue is less than price and average revenue. Because Manny is a monopolistically competitive restauranteer who has some degree of market control and faces a negatively-sloped demand curve, each EXTRA sandwich he sells generates less EXTRA revenue than the price.
Breakeven OutputThe condition that price equals both short-run average total cost and long-run average cost (P = ATC = LRAC) indicates that a firm is producing breakeven output, earning exactly a normal profit. Manny, the monopolistically competitive firm, is not receiving an economic profit nor incurring an economic loss.
This condition further means that firms have no incentive to enter or exit the industry. If no firms IN the monopolistically competitive industry receive above-normal economic profit, then there is no incentive for other firms to enter the industry. If no firms IN the monopolistically competitive industry incur economic loss or receive below-normal profit, then there is no incentive for any firms to exit the industry.
Consider the $4.95 price that Manny receives for his sandwiches. Because this price is equal to the short-run average total cost and the long-run average cost of producing meals, Manny earns exactly a normal profit. Note that normal profit is included as a cost of production. Because Manny is earning a normal profit, he has no incentive to switch from sandwich production to an alternative industry, such as macrame plant holder production.
Normal profit is the profit that Manny could be earning in another activity, such as macrame plant holder production. Because this is equal to the profit he is earning in sandwich production, there is no reason to change. There is no reason to leave the sandwich industry in search of greater profit on the other side of the shopping mall. Felicity the macrame plant holder producer reaches the same conclusion. Her macrame plant holder profit is the same as Manny's sandwich profit. She has no incentive to leave the macrame plant holder industry and enter the sandwich industry.
What would happen, however, if price is not equal to average cost.
Only when the condition (P = ATC = LRAC) is satisfied do firms earn exactly a normal profit, receiving neither an economic profit nor incurring an economic loss. And only when this condition is satisfied is there no incentive for firms to enter or exit an industry. This condition is satisfied by a monopolistically competitive industry in the long run.
- Suppose, for example, that the sandwich price ($4.95) is greater than the average total cost of producing sandwiches (say $3.95). In this case, Manny receives $1 of economic profit for each sandwich sold. Because this exceeds the zero economic profit earned by Felicity the macrame plant holder maker, Felicity is induced to leave macrame plant holder production and take up sandwich production.
- Alternatively, if the sandwich price ($4.95) is less than the average total cost of producing sandwiches (say $5.95), then Manny incurs an economic loss of $1 for each sandwich sold. Because he much prefers NOT to incur an economic loss, he is attracted to the zero economic profit (that is, normal profit) earned by Felicity the macrame plant holder maker. Manny is induced to leave sandwich production and take up macrame plant holder production.
Excess CapacityThe condition that short-run average total cost exceeds short-run marginal cost equals (ATC > MC) means that a firm is NOT operating at the minimum point of its short-run average total cost curve. In fact, this condition means that the firm is producing a smaller quantity than that achieved at this minimum point. Moreover, this means that a firm is NOT producing output at the lowest possible per unit cost and that the capital (or factory) is NOT being used in the most technically efficient manner possible.
Because the average cost of Manny's sandwich production is greater than marginal cost, Manny is operating to the left of the minimum point on his short-run average total cost curve. Manny can actually produce sandwiches at a lower per unit cost, given his existing capital (the current size of his restaurant and his array of kitchen tools), by increasing production. And in so doing, the average cost of production would decline.
Long-run equilibrium for a monopolistically competitive industry achieves the condition that ATC > MC. This means that each firm produces less output than could be achieved by fully using the available capacity of the plant size.
Economies of ScaleThe condition that long-run average cost is greater than long-run marginal cost (LRAC > LRMC) means that a firm is operating to the left of the minimum point of its long-run average cost curve (the minimum efficient scale of production). This is the economies of scale range of production, characterized by a negatively-sloped long-run average cost curve. This condition means a firm has NOT constructed the most technically efficient factory. The firm is NOT producing output at the lowest possible long-run per unit cost. By increasing production, long-run average cost decreases.
When the long-run average cost exceeds long-run marginal cost, Manny's sandwich production is not at the minimum point on his long-run average cost curve. Manny can produce meals at a lower per unit cost in the long run by taking advantage of economies of scale, such as volume resource price discounts, input specialization, etc.
Long-run equilibrium for a monopolistically competitive industry achieves the condition (LRMC > LRAC), which means that firms are not producing output at the lowest possible per unit cost.
MONOPOLISTIC COMPETITION, LONG-RUN EQUILIBRIUM CONDITIONS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2022. [Accessed: May 26, 2022].