Monopolistic Competition
Product differentiation, short-run profits, and long-run zero-profit.
What this graph shows
This is the monopolistic competition model, showing a firm with a differentiated product and some pricing power but facing free entry from rivals. It has a downward demand curve, a dashed marginal revenue curve below it, a rising marginal cost curve, and a U-shaped average total cost curve, like a monopoly diagram but with a twist over time.
Drag the demand and cost curves, then toggle between Short Run and Long Run. In the short run the firm can earn economic profit or loss, shown as a shaded rectangle. Switch to the long run and entry has competed that profit away until price equals average total cost, and the graph reveals the excess capacity gap that defines this structure.
How to read it
Dollars are on the vertical axis, quantity on the horizontal. Find quantity where marginal revenue meets marginal cost, drop down to read Q, then go up to the demand curve for the price P. In the short run, compare price to ATC at that quantity for the profit or loss rectangle. In the long run demand has shifted until it just touches ATC there, so profit is zero, and the green arrow measures excess capacity, the gap between the firm's output Q and the efficient scale Q* where ATC is lowest.
Three things to try
- Start in Short Run with a profit showing, then click Switch to Long Run and watch demand pull back until the profit rectangle disappears and price sits right on the ATC curve.
- In Long Run mode, follow the green excess capacity arrow from the firm's quantity Q out to Q*, the low point of ATC, to see how far below efficient scale the firm operates.
- Drag the demand curve left in Short Run until the rectangle turns red, showing an economic loss that would push firms to exit the market.
Common questions
Why is long-run profit zero in monopolistic competition?
Because entry is free, new firms keep entering whenever there is profit, which pulls each existing firm's demand curve left. This continues until demand is just tangent to average total cost, so price equals ATC and economic profit is zero.
What is excess capacity on this graph?
Excess capacity is the horizontal gap between the firm's actual output and the quantity at the bottom of the average total cost curve, the efficient scale. The green arrow shows that a monopolistically competitive firm always produces less than the output that would minimize average cost.
How is this graph different from a monopoly graph?
The curves look almost identical in the short run, but monopolistic competition adds free entry, so the long-run version shows demand shifting until profit is zero. A monopoly can keep its profit because entry is blocked, while this firm cannot.
Monopolistic Competition: key terms
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