Monopolistic Competition: Long-Run Equilibrium and Excess Capacity

Twelve coffee shops share a few blocks, and none of them is getting rich. Why not, when each has regulars who rarely drink anywhere else? Those regulars let a shop nudge its price up and keep most of them. So where does the money go? This is Module 4.4, Monopolistic Competition: part monopoly, part competition.

Monopolistic competition has three features: many firms, differentiated products, and free entry and exit in the long run. Differentiated means each firm sells something a bit different: another roast, a closer corner, a cozier room. Buyers see close substitutes, not identical ones. That difference gives each shop some market power. Raise the price a little and it loses some customers, not all. So its demand curve slopes down.

Quick refresher from Module 4.2: to sell one more cup, the shop must cut the price on every cup. Three cups at $6 bring in $18; four cups at $5 bring in $20. The fourth cup adds just $2, less than its $5 price.

So what just happened? One: differentiation gives each shop a downward-sloping demand. Two: the fourth cup sold for $5 but added only $2. Three: so MR lies below demand, just as in monopoly.

Short run first. Draw it like a monopoly graph: Price, Cost up the vertical axis and Quantity along the horizontal; demand, D1, and marginal revenue, MR1, from the same point, with MR1 below D1 and reaching the quantity axis. Add a rising marginal cost curve, MC. The shop's best quantity, Q1, is where MR1 crosses MC: 450 cups a day.

Quick refresher: profit peaks where MR equals MC. Then go up from Q1 to the demand curve and across for the price, P1: $7 a cup. Never read the price where MR crosses MC.

Now average total cost, ATC: a U shape, with MC rising through its lowest point. At 450 cups, ATC is $3, below the $7 price.

Quick refresher from Unit 3: economic profit is price minus ATC, times quantity: a rectangle whose height is profit per cup and whose width is cups sold.

Height: $7 minus $3 is $4 a cup. Width: 450 cups. Profit: $4 times 450 is $1,800 a day.

So what just happened? One: MR1 meets MC at 450 cups. Two: up to demand, the price is $7. Three: ATC is $3, so profit is $4 times 450: $1,800 a day.

The short run can also bring a loss. If ATC sits above the demand curve at every quantity, price minus ATC is negative even at the best quantity. If ATC just touches demand there, profit is zero. Exam trap: on a released monopoly question, a loss needed ATC above demand. ATC below demand, or just touching it, missed the point; fewer than half earned it. Touching means zero profit, not a loss.

Now the long run. That $1,800 a day is a loud signal, and there are no barriers to entry. New coffee shops open nearby.

Quick refresher from Module 3.7: in perfect competition, profit draws firms in, market supply shifts right, and the price falls until economic profit is zero.

Here, the curve that moves is our shop's own demand. Each new shop pulls away some customers, so at every price ours sells fewer cups: demand shifts left, D1 to D2, and MR shifts with it, MR1 to MR2. D2 is also more elastic. With more close substitutes nearby, the same price rise now drives away more buyers.

Quick refresher from Unit 2: elasticity is the percent change in quantity demanded divided by the percent change in price. Say a 10% price rise once cost 15% of sales: 15 divided by 10 is 1.5. With rivals next door, it might cost 30%: that's 3.

Exam trap: entry moves each firm's demand, not a supply curve. If you shift supply, you're drawing the perfect competition picture. Entry stops when there's no profit left to chase: when D2 just touches ATC, right above the quantity where MR2 equals MC. Our shop now sells 200 cups a day, labeled Q2, where MR2 meets MC. Up to D2: the price, P2, is $4. And ATC at 200 cups is also $4. Profit: $4 minus $4, times 200, is zero. That's normal profit, so no one has a reason to enter or leave.

That answers the opening question. Every shop has regulars, but any profit pulls in new shops until each one just covers its costs.

So what just happened? One: $1,800 a day drew new shops in. Two: our shop's demand and MR shifted left. Three: at 200 cups, price and ATC are both $4: zero profit.

Losses run it in reverse: some shops close, each survivor's demand and MR shift right, and the losses shrink to zero. Exam trap: long-run profit is zero because price equals ATC. Not because price equals marginal cost, and not at the bottom of ATC. Those are perfect competition answers.

So how does this long run compare with perfect competition? Both end with many firms and zero economic profit. Two things differ.

Quick refresher from Module 3.7: a perfectly competitive firm ends at the bottom of ATC, which is productive efficiency, with price equal to marginal cost, which is allocative efficiency.

First: our shop's ATC keeps falling until 600 cups a day, but it makes only 200. Making less than the output that minimizes ATC is called excess capacity: here, 400 cups. So it is not productively efficient. Second: at 200 cups, the price is $4 but marginal cost is $2. The next cup is worth almost $4 to a buyer and costs about $2 to make, yet no one makes it: allocative inefficiency.

So what just happened? One: 200 cups, not the 600 at ATC's bottom: excess capacity, so not productively efficient. Two: a $4 price above a $2 marginal cost: allocative inefficiency. Three: profit is still zero.

Buyers do get more variety. But the exam's long-run verdict: excess capacity and price above marginal cost, so neither productively nor allocatively efficient.

How do firms differentiate? By style or type, like an espresso bar versus a tea house. By location, like the shop on your corner. And by quality, like a basic drip versus a hand-poured cup. Firms also advertise to make their product stand out. Why pay for ads? With a $4 price and a $2 marginal cost, each extra customer at that price adds $2 of profit. A perfectly competitive firm already sells all it wants at the market price, so it has no reason to advertise its own product.

So what just happened? One: firms differentiate by style, location and quality. Two: price above marginal cost makes each extra customer worth $2, so they advertise. Three: price takers don't.

Exam moment: two questions the way the AP exam asks them, then one free-response part.

Question 1. A monopolistically competitive bakery is in long-run equilibrium. It sells 40 loaves a day at $6 each, where marginal revenue and marginal cost both equal $3. Its average total cost is lowest, $5, at 80 loaves. What is its daily economic profit? A) $0 B) $40 C) $80 D) $120 E) $240

The answer is A. In long-run equilibrium, price equals ATC, so ATC at 40 loaves is $6. Profit is $6 minus $6, times 40: zero. B uses ATC's lowest point, $5. C jumps to that point, 80 loaves, but keeps the $6 price. D treats marginal cost as ATC. E is total revenue.

Question 2. Dog groomers in a city are monopolistically competitive and earn positive economic profit. As new groomers open, what happens to a typical existing groomer? A) Its demand and marginal revenue both shift right. B) Its demand and marginal revenue both shift left. C) Its demand shifts left; its marginal revenue stays put. D) Its demand stays put; its quantity demanded falls. E) Market supply shifts right; its demand stays put.

The answer is B. New groomers are close substitutes, so each existing groomer sells less at every price: demand shifts left, and marginal revenue shifts with it. A is what exit does. C forgets that MR moves with demand. D confuses a demand shift with a move along it. E borrows the supply shift from perfect competition.

Free response, 1 point. Lantern Ramen, a monopolistically competitive restaurant, earns positive economic profit as new ramen shops open nearby. Will the demand for Lantern Ramen's meals become more elastic, become less elastic, or stay the same? Explain.

What earns the point: more elastic, plus the reason. The new shops are close substitutes, so Lantern's buyers respond more to a change in its price. The costly mistakes: less elastic, no change, elastic without the word more, or no reason. When a recent AP exam asked this about a monopoly whose patent expired, more than one student in three missed it.

So what earned the point? One: more elastic, with the word more. Two: the reason, more close substitutes. Three: so buyers respond more to its price.

Recap: in the short run, it's a monopoly graph, with profit or loss. Entry or exit moves each firm's demand until it just touches ATC: zero profit. In the long run: excess capacity, and price above MC. Next: Module 4.5, Oligopoly and Game Theory: the payoff matrix.