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Difficulty: MediumComparison of Market Structures: Economic Efficiency and Consumer Welfare

In long-run equilibrium, a firm operating in a monopolistically competitive market structure achieves allocative efficiency because free entry drives economic profits down to zero.

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Answer

False. Monopolistically competitive firms do not achieve allocative efficiency in the long run because price exceeds marginal cost (P>MCP > MC), despite earning zero economic profit (P=ATCP = ATC).
The statement is false. Allocative efficiency requires price to equal marginal cost (P=MCP = MC). Under monopolistic competition, product differentiation produces a downward-sloping demand curve where P>MRP > MR. Because the firm sets MR=MCMR = MC, price remains greater than marginal cost (P>MCP > MC) in the long run, even though free entry reduces economic profit to zero (P=ATCP = ATC).

Step-by-Step Solution

1
Define allocative efficiency.
Allocative efficiency is achieved when price equals marginal cost (P=MCP = MC), meaning societal welfare is maximized.
This is the benchmark condition for economic efficiency.
2
Analyze the long-run equilibrium condition for monopolistic competition.
Free entry and exit ensure that firms earn zero economic profit in the long run, which occurs where price equals average total cost (P=ATCP = ATC).
New firms enter when positive profits exist, shifting individual firm demand curves leftward until demand is tangent to the ATC curve.
3
Compare price with marginal cost at output decision.
Because the product is differentiated, demand slopes downward (P>MRP > MR). The firm maximizes profit where MR=MCMR = MC, implying P>MCP > MC at equilibrium.
Since P>MCP > MC, the market suffers from allocative inefficiency and excess capacity.

Key Concept

Comparison of Long-Run Economic Efficiency Across Market Structures
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Topics

Comparison of Market Structures: Economic Efficiency and Consumer Welfare

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