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AP® Microeconomics · Unit 4 · Topic 4.4

Monopolistic Competition: Study Guide (Microeconomics 4.4)

Learn how firms selling differentiated products set price and output, why short-run profits or losses disappear in the long run, and why long-run equilibrium shows excess capacity and price above marginal cost.

A market between two extremes

Think of the cafés, hairdressers, restaurants or clothing shops in a large town. There are many of them, and opening a new one is not hard. But each one is a little different: its location, its menu, its style, its service. That combination is called monopolistic competition. It has features of both perfect competition and monopoly.

Feature Monopolistic competition
Number of firms many, each small relative to the market
Product differentiated: similar, but not identical (close substitutes)
Entry and exit easy: low barriers to entry in the long run
Each firm’s demand curve downward-sloping, but quite elastic, because rivals sell close substitutes
Price-setting each firm has a little market power over its own product
Non-price competition common: advertising, branding, quality, location, service

Because the product is differentiated, a café that raises its price a little loses some customers but not all of them. Its demand curve slopes down, so like a monopolist it must lower its price to sell more, and its MR curve lies below its demand curve. But because there are many close substitutes, that demand is fairly elastic.

Differentiation and advertising

Firms try to make their product stand out. They change the product itself (recipes, design, quality), where and when they sell it (location, opening hours), the service around it, and how buyers see it (brand name, packaging, advertising).

Advertising has two aims:

  1. Raise demand for this firm’s product (shift its demand curve to the right).
  2. Make demand less elastic by persuading buyers that rivals’ products are poorer substitutes, so the firm can charge more without losing many customers.

Advertising also has a cost. It is usually a fixed cost (it does not depend on how many units are sold), so it raises ATC but does not change MC. An advertising campaign pays only if the extra revenue is larger than its cost. And in the long run, if advertising makes profits, rivals copy it and new firms enter, so the profit does not last.

The short run: profit, loss or zero

In the short run the number of firms is fixed. Each firm uses the same rule as any other firm:

  1. Produce where MR = MC.
  2. Read the price up to the demand curve at that quantity.
  3. Compare price with ATC at that quantity:
    • P > ATC: economic profit = (P − ATC) × Q;
    • P < ATC: economic loss = (ATC − P) × Q;
    • P = ATC: zero economic profit (a normal profit).

A firm making a loss keeps producing in the short run if price covers average variable cost (P ≥ AVC), because it then loses no more than its fixed cost (which it would lose anyway by shutting down). If P < AVC at every output, it shuts down in the short run.

The short-run graph looks just like the monopoly graph from Topic 4.2. The difference shows up in the long run.

Worked example 1: a café from short run to long run

Question. Kettle & Fern is one of many cafés in the fictional town of Brackwater. Its coffee is a little different from its rivals’. Its costs are TC = 200 + Q + 0.005Q² (Q = cups per day, in dollars), so MC = 1 + 0.01Q. Its demand is P = 7.4 − 0.015Q, so MR = 7.4 − 0.03Q.

(a) Find its profit-maximising output and price, and its economic profit or loss. (b) Explain what happens in the long run. (c) In the long run its demand becomes P = 5 − 0.015Q. Find the new output, price and profit, and show that the new demand curve just touches ATC.

Kettle and Fern café in the short run, making an economic profit Graph with quantity in cups per day on the horizontal axis, 0 to 420, and price and cost in dollars per cup on the vertical axis, 0 to 8. A downward-sloping demand curve starts at 7.40 dollars. The marginal revenue curve starts at the same point and falls twice as steeply. The marginal cost curve rises from 1 dollar. The U-shaped average total cost curve reaches its minimum of 3 dollars at 200 cups. Marginal revenue equals marginal cost at 160 cups. At 160 cups the price on the demand curve is 5.00 dollars and average total cost is 3.05 dollars. The rectangle between 3.05 and 5.00 dollars from 0 to 160 cups is shaded and labelled profit equals 312 dollars. 0 100 200 300 400 2 4 6 8 5.00 3.05 Quantity (cups per day) Price and cost ($ per cup) Q = 160 Profit = $312 D MR MC ATC
Figure 1. Short run. MR (dashed) meets MC (solid, rising) at 160 cups. The price on demand (solid, falling) is $5.00 and ATC (dotted U-shape) is $3.05, so the shaded rectangle is an economic profit of $312 per day.

(a)

  1. Set MR = MC: 7.4 − 0.03Q = 1 + 0.01Q, so 6.4 = 0.04Q and Q = 160 cups per day.
  2. Price from demand: P = 7.4 − 0.015 × 160 = 7.4 − 2.4 = $5.00.
  3. ATC at 160 = 200 ÷ 160 + 1 + 0.005 × 160 = 1.25 + 1 + 0.80 = $3.05.
  4. Economic profit = (5.00 − 3.05) × 160 = $312 per day.

(b) Cafés in Brackwater are earning economic profits, and entry is easy. New cafés open. Each new café takes some of Kettle & Fern’s customers, and gives the remaining ones more close substitutes. So Kettle & Fern’s demand curve shifts left and becomes more elastic. Entry continues until there is no economic profit left to attract new firms.

(c)

  1. New MR = 5 − 0.03Q. Set MR = MC: 5 − 0.03Q = 1 + 0.01Q, so Q = 100 cups per day.
  2. P = 5 − 0.015 × 100 = $3.50.
  3. ATC at 100 = 200 ÷ 100 + 1 + 0.005 × 100 = 2 + 1 + 0.5 = $3.50.
  4. Economic profit = (3.50 − 3.50) × 100 = $0.

Check. At Q = 100 the demand curve and the ATC curve meet at $3.50, and both have the same slope there (each falls by $0.015 per extra cup), so demand touches ATC without crossing it. At every other quantity ATC is above demand, so no output can earn a profit. This tangency is the long-run equilibrium.

The long run: zero economic profit

Free entry and exit drive every firm to zero economic profit:

  • Profits → firms enter → each firm’s demand shifts left (and becomes more elastic) → profit falls until P = ATC.
  • Losses → some firms leave → the customers of those firms go to the remaining firms → each remaining firm’s demand shifts right (and becomes less elastic) → the loss shrinks until P = ATC.

In long-run equilibrium, at the quantity where MR = MC, the demand curve is tangent to the ATC curve, so P = ATC.

Kettle and Fern café in long-run equilibrium Same axes and cost curves as Figure 1. The long-run demand curve starts at 5 dollars and is tangent to the average total cost curve at 100 cups and 3.50 dollars. The long-run marginal revenue curve starts at 5 dollars and meets marginal cost at 100 cups, where marginal cost is 2 dollars. The minimum of average total cost is 3 dollars at 200 cups. A bracket below the quantity axis from 100 to 200 cups is labelled excess capacity. A hatched triangle between the demand curve and the marginal cost curve, from 100 cups to 160 cups where demand meets marginal cost at 2.60 dollars, is labelled deadweight loss equals 45 dollars. 0 100 200 300 400 4 6 8 3.50 2.00 excess capacity (100 cups) Quantity (cups per day) Price and cost ($ per cup) P = ATC = 3.50 minimum ATC = 3.00 DWL = 45 D MR MC ATC
Figure 2. Long run. Demand (solid, falling) touches ATC (dotted) at 100 cups and $3.50, so economic profit is zero. Output is 100 cups below the minimum-ATC output of 200 (excess capacity), and P = $3.50 is above MC = $2.00, leaving the hatched deadweight loss.

Why the long run is inefficient

The tangency must happen on the downward-sloping part of ATC, because the demand curve slopes down. That has two results.

1. Excess capacity (not productively efficient). The firm produces less than the quantity that minimises ATC. Kettle & Fern makes 100 cups, but its ATC would be lowest ($3.00) at 200 cups. The gap of 100 cups is its excess capacity. Each cup costs more to make than it would at minimum ATC ($3.50 rather than $3.00).

2. Allocative inefficiency. Price is greater than marginal cost: $3.50 > $2.00. Some buyers value an extra cup at more than the $2.00 it costs to make, but they do not get it. Kettle & Fern’s demand curve is above its MC curve from 100 cups until they meet at 160 cups ($2.60). The deadweight loss is the triangle between them:

DWL = ½ × (160 − 100) × (3.50 − 2.00) = ½ × 60 × 1.50 = $45 per day.

You can find the other areas in the same way. Consumer surplus is the triangle above the price and below demand: ½ × 100 × (5.00 − 3.50) = $75 per day. Producer surplus is revenue minus variable cost: 3.50 × 100 − (1 × 100 + 0.005 × 100²) = 350 − 150 = $200 per day. That is exactly the $200 fixed cost, which is another way to see that economic profit is zero.

There is a balancing point. Excess capacity and a price above minimum ATC can be seen as the cost of variety. Buyers get many slightly different cafés, menus and locations to choose from, which they may value.

Long run Perfect competition Monopolistic competition Monopoly
Economic profit zero zero can be positive (barriers to entry)
Price and MC P = MC P > MC P > MC
Price and ATC P = minimum ATC P = ATC, above minimum P can exceed ATC
Productively efficient? yes no (excess capacity) usually no
Allocatively efficient? yes no (deadweight loss) no

Worked example 2: a barber’s loss, from a table

Question. Tidewell Barbers is one of many barbers in a fictional city. Its fixed costs are $450 per day. The table shows its demand and total cost.

Haircuts per day (Q) 10 20 30 40 50
Price ($) 27 24 21 18 15
Total cost ($) 520 610 720 850 1,000

(a) Find the profit-maximising output and the profit or loss. (b) Should Tidewell stay open in the short run? (c) Explain what happens in the long run.

(a) Work out total revenue (TR = P × Q) and profit (TR − TC).

Q 10 20 30 40 50
TR ($) 270 480 630 720 750
Profit ($) −250 −130 −90 −130 −250

The best Tidewell can do is 30 haircuts at $21, with a loss of $90 per day. Check with marginal values: from 20 to 30 haircuts, MR = (630 − 480) ÷ 10 = $15 per haircut and MC = (720 − 610) ÷ 10 = $11, so expanding pays. From 30 to 40, MR = $9 and MC = $13, so it does not.

(b) At 30 haircuts, variable cost = 720 − 450 = $270, so AVC = 270 ÷ 30 = $9. Price ($21) is above AVC, so Tidewell covers its variable costs and has $360 left towards its $450 of fixed costs. Staying open loses $90; shutting down would lose all $450 of fixed costs. It should stay open in the short run.

(c) Barbers in the city are making losses, so in the long run some of them leave the market. Their customers move to the barbers that remain. Tidewell’s demand shifts right and becomes less elastic, until price equals ATC at the profit-maximising output. For example, if Tidewell’s demand became P = 36 − 0.4Q, it would cut 30 haircuts at $24, and its ATC at 30 haircuts is 720 ÷ 30 = $24, so economic profit would be zero. Its output of 30 would still be below the output that minimises ATC (about 67 haircuts per day), so excess capacity remains.

Common misconceptions

  • “Monopolistically competitive firms make long-run profits because they have market power.” Their market power is small and entry is free. New firms compete away any economic profit.
  • “In the long run, the firm produces at minimum ATC, like a perfectly competitive firm.” The demand curve slopes down, so it touches ATC to the left of the minimum. That is excess capacity.
  • “The long-run tangency is where MC crosses ATC.” MC crosses ATC at the minimum of ATC. The tangency is between demand and ATC, at a smaller quantity.
  • “Zero economic profit means the owners earn nothing.” It means a normal profit: revenue covers every cost, including the owners’ opportunity cost.
  • “Entry shifts the market supply curve, so the firm’s demand stays the same.” In this model, entry moves each firm’s own demand curve to the left, because customers are shared among more firms.
  • “Advertising shifts the MC curve up.” Advertising is usually a fixed cost, so it raises ATC, not MC.
  • “Reading the price from MR.” As in monopoly, the price comes from the demand curve above the MR = MC quantity.

Where this leads

Monopolistic competition has many firms that ignore each other’s reactions. Next, Topic 4.5: Oligopoly and Game Theory looks at markets with a few firms whose choices depend on what their rivals do. Test yourself with the practice questions, then use the revision notes and the checklist to consolidate.

Quick questions

If firms earn zero economic profit in the long run, why do they stay in business?

Zero economic profit means total revenue covers all costs, including the owners' opportunity costs. The owners earn a normal return, as much as they could earn in their next best use of the money and time.

How is this different from perfect competition in the long run?

Both end at zero economic profit, because entry is free. But in perfect competition each firm's demand is horizontal, so it is tangent to ATC at its minimum and P = MC. In monopolistic competition demand slopes down, so the tangency is to the left of minimum ATC and P > MC.

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