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

Inefficiency

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 Alternative

A comparison between monopolistic competition and perfect competition indicates:

• 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.