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Difficulty: MediumMonopolistic Competition: Features, Product Differentiation, and Equilibrium

In long-run equilibrium, a firm operating under monopolistic competition sets output where marginal revenue equals marginal cost, and its downward-sloping demand curve is tangent to its average total cost curve. Which of the following best describes the long-run outcome for this firm?

  1. The firm earns only normal profit and operates with excess capacity.Answer
  2. B
    The firm earns economic profit in the long run because price exceeds marginal cost.
  3. C
    The firm achieves productive efficiency by producing at the minimum average total cost.
  4. D
    The firm achieves allocative efficiency by setting price equal to marginal revenue.

Answer

The firm earns only normal profit and operates with excess capacity.
In long-run equilibrium under monopolistic competition, freedom of entry ensures that firms earn only normal profits (P=ATCP = ATC). Because product differentiation gives each firm a downward-sloping demand curve, tangency with the U-shaped ATC curve occurs to the left of its minimum, resulting in excess capacity.

Step-by-Step Solution

1
Analyze entry and profit in the long run for monopolistic competition.
Free entry of firms attracts new producers whenever short-run economic profits exist, shifting the demand curve for each individual firm to the left until price equals average total cost (P=ATCP = ATC), yielding zero economic (normal) profit.
Free entry and exit is a key feature of monopolistic competition.
2
Determine the output level relative to the minimum average total cost.
Because the firm's demand (average revenue) curve is downward-sloping due to product differentiation, the point of tangency with the ATC curve occurs on the downward-sloping section of the ATC curve, to the left of its minimum point.
A downward-sloping line can only be tangent to a U-shaped curve at a point where the curve is sloped downward.
3
Identify the economic implication of this equilibrium point.
Producing to the left of the minimum point of the ATC curve means the firm produces less than the capacity-minimizing cost output level, creating excess capacity.
Excess capacity represents the difference between the profit-maximizing output and the output that minimizes average cost.

Key Concept

Long-Run Equilibrium and Excess Capacity in Monopolistic Competition
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Topics

Monopolistic Competition: Features, Product Differentiation, and Equilibrium

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