4.4 Monopolistic Competition

Monopolistic competition combines many sellers, differentiated products, and low barriers to entry, think restaurants or clothing brands. Differentiation (real or created by advertising) gives each firm a downward-sloping demand curve, though a relatively elastic one because close substitutes exist.

In the short run the graph looks like a monopoly's: produce where MR = MC, charge the demand-curve price, and earn a profit or loss depending on where ATC sits. But low barriers mean profit attracts entry. New rivals pull customers away, shifting each firm's demand curve left until it is just tangent to ATC at the MR = MC quantity, price equals ATC and economic profit is zero (firms earn only normal profit).

That long-run tangency happens on the downward-sloping part of ATC, so the firm is neither productively efficient (P > minimum ATC) nor allocatively efficient (P > MC). The gap between its output and the minimum-ATC output is excess capacity, the efficiency cost society pays for product variety.