The Performance of Firms in Monopolistic Competition (Cambridge (CIE) A Level Economics): Revision Note

Short-run supernormal profits in monopolistic competition

• In order to maximise profit, firms in monopolistic competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)

  • The firm can make supernormal profit in the short-run

• The average revenue (AR) curve is the demand curve of the firm and it is downward sloping

•  The firm has some market power due to the level of product differentiation that exists

  • To sell an additional unit of output, the firm will have to decrease its price

  • The marginal revenue (MR) curve will fall twice as quickly as the average revenue curve (AR)

• A very good example of how this occurs can be seen in the barber shop industry. 

  • Innovators may offer unique features such as free espressos, or childcare while you wait

  • This permits them to charge higher prices until such a point as competitors copy their innovative actions

  • Their abnormal profit will then be eroded

Short-run profits for a monopolistically competitive firm

Diagram analysis

• The firm produces at the profit maximisation level of output, where MC = MR (Q₁)

  • At this level, AR (P₁) > AC (C₁)

  • The firm is making supernormal profit

Short-run losses in monopolistic competition

• Firms in monopolistic competition are able to make losses in the short-run

Short-run losses in monopolistic competition

Diagram analysis

• The firm produces at the profit maximisation level of output, where MC = MR (Q_E)

  • At this level of output, the AR (P_E) < ATC (C₁)

  • The firm's loss is =

Long-run normal profit in monopolistic competition

From supernormal to normal Profit

• If firms in monopolistic competition make supernormal profit in the short-run, new entrants are attracted to the industry, and the number of sellers increases

  • They are incentivised by the opportunity to make supernormal profit

  • There are low barriers to entry and It is easy to join the industry

• Supernormal profit will be eroded, and the firm will return to the long-run equilibrium position of making normal profit

From losses to normal profit

• If firms in monopolistic competition make losses in the short-run, some will shut down

  • The shut down rule will determine which firms shut down

  • There are low barriers to exit, so it is easy to leave the industry

• For the remaining firms, losses will be eliminated, and the firm will return to the long-run equilibrium position of making normal profit

Long-run normal profit position

Diagram analysis

• The firm is producing at the profit maximisation level of output, where MC=MR (Q₁)

• At this level of output, P₁ = AC and the firm is making normal profit

• In the long-run, firms in monopolistic competition always make normal profit

  • Firms making a loss leave the industry

  • Firms making supernormal profit see it slowly eradicated as new firms join the industry

Efficiency in monopolistic competition

• Allocative efficiency occurs where average revenue = marginal cost (AR = MC)

• In monopolistic competition firms produce where MR = MC, but P > MC

  • This means firms do not achieve allocative efficiency

• Productive efficiency occurs where marginal cost = average cost (MC = AC)

  • This is the point where average costs are minimised

• Firms in monopolistic competition do not achieve productive efficiency

  • They produce to the left of the minimum point of the AC curve, meaning there is excess capacity

Diagram analysis

• The firm maximises profit where MR = MC, which occurs at point A, producing Q

• At this level of output, the firm charges price P from the AR (demand) curve

• Because P > MC, the firm is not allocatively efficient

• Allocative efficiency would occur where AR = MC

• The firm is also not productively efficient, because it is not producing at the minimum point of the AC curve (point X)