Monopolistic Competition in the Long Run

Monopolistic competition from short run to long run

A major factor in the short run is that firms can make profits or incur losses in a monopolistic competition. If the market price is above the average total cost at the equilibrium output level, then the firm will make a profit in the short run. If the average total cost is above the market price, then the firm will incur losses in the short run.

However, the equilibrium level is the major factor in the long run, where firms will earn zero economic profit in a monopolistic competition. The market would not be at equilibrium in the long run if the current firms are making profits.

As we assume there is free entry in the market and some firms are making a profit, then new firms want to enter the market as well. The market would be at equilibrium only after the profits will be eliminated with the new firms entering the market.

The firms that are incurring losses are not at equilibrium in the long run. If the firms are losing money, they have to exit the market eventually. The market is only at equilibrium, once the firms that are incurring losses will be eliminated.

Examples of Monopolistic Competition in the Long Run

How do firms that enter the market or the ones that exit the market affect the existing firms in the market? The answer lies in the demand. Although the firms differentiate their products, they are in competition and the number of potential buyers stays the same.

What happens to the firms in the market if other firms exit? Let's say the first bakery decides to close, then the demand for the second bakery would increase significantly. The customers of the first bakery now have to decide between two options: buying from the second bakery or not buying at all (preparing the breakfast at home for instance). Since we assume a certain amount of demand in the market, it would be very likely that at least some of the customers from the first bakery start to shop from the second bakery. As we see in this bakery example demand for - yummy goods - is the factor that limits how many firms exist in the market.

Demand curve shifts and long Run Monopolistic Competition

Since the entry or exit of the firms will affect the demand curve, it has a direct effect on the existing firms in the market. What does the effect depend on? The effect depends on whether the existing firms are profitable or incurring losses. In Figures 1 and 2, we will look at each case closely.

If the existing firms are making a profit, then new firms have an incentive to enter the market.

Since the available demand in the market splits among the firms active in the market, with each new firm in the market, the available demand for the firms that already exist in the market decreases. We see this in the bakery example, where the entry of the second bakery decreases the available demand for the first bakery.

In Figure 1 below, we see that the demand curve of the existing firms shifts leftwards (from D₁ to D₂) since new firms are entering the market. Consequently, the marginal revenue curve of each firm also shifts leftwards (from MR₁ to MR₂ ).

Accordingly, as you can see in figure 1, the price will decrease and the overall profit will fall. The new firms stop entering until the firms start making zero profit in the long run.

In a separate scenario, consider, that if the existing firms are incurring a loss, then exit will occur in the market.

Since the available demand in the market splits among the firms active in the market, with each firm exiting the market, the available demand for the remainşng firms in the market increases. We see this in the bakery example, where the exit of the first bakery increases the available demand for the second bakery.

We can see the demand change in this case in Figure 2 below. Since the number of existing firms decreases, there is a rightwards shift (from D₁ to D₂) in the demand curve of existing firms. Accordingly, their marginal revenue curve is shifted rightwards (from MR₁ to MR₂).

Fig 2. - Exit of Firms in Monopolistic Competition

The firms that do not exit the market will experience increased demand and thus start receiving higher prices for each product and their profit increases (or loss decrease). The firms stop exiting the market until the firms start making zero profit.

Long Run Equilibrium under Monopolistic Competition

The market will be at equilibrium in the long run only if there is no exit or entry in the market anymore. The firms will not exit or enter the market only if every firm makes zero profit. This is the reason why we name this market structure monopolistic competition. In the long run, all firms make zero profit just as we see in perfect competition. At their profit-maximizing output quantities, the firms just manage to cover their costs.

Graphical representation of monopolistic competition in the long run

If the market price is above the average total cost at the equilibrium output level, then the firm will make a profit. If the average total cost is above the market price, then the firm incurs losses. At the zero-profit equilibrium, we should have a situation between both cases, namely, the demand curve and the average total cost curve should touch. This is only the case where the demand curve and the average total cost curve are tangent to each other at the equilibrium output level.

In Figure 3, we can see a firm in monopolistic competition and is making zero profit in the long-run equilibrium. As we see, the equilibrium quantity is defined by the intersection point of the MR and MC curve, namely at A.

Fig 3. - Long Run Equilibrium in Monopolistic Competition

We can also read the corresponding quantity (Q) and the price (P) at the equilibrium output level. At point B, the corresponding point at the equilibrium output level, the demand curve is tangent to the average total cost curve.

If we want to calculate the profit, normally we take the difference between the demand curve and the average total cost and multiply the difference with the equilibrium output. However, the difference is 0 since the curves are tangent. As we expect, the firm is making zero profit in the equilibrium.

Characteristics of Monopolistic Competition in the Long Run

In the long run monopolistic competition, we see that the firms produce a quantity where the MR equals MC. At this point, demand is tangent to the average total cost curve. However, at the lowest point of the average total cost curve, the firm could produce more quantity and minimize the average total cost(Q₂) as seen in figure 4 below.

Excess capacity: monopolistic competition in long run

Since the firm produces below its minimum efficient scale - where the average total cost curve is minimized- there is an inefficiency in the market. In such a case, the firm could increase the production but produce more than the capacity in the equilibrium. Thus we say the firm has excess capacity.

Fig 4. - Excess Capacity in Monopolistic Competition in Long Run

In Figure 4 above, an excess capacity issue is illustrated. The difference that the firms produce(Q₁₎ and the output at which the average total cost is minimized(Q₂) is called excess capacity(from Q₁ to Q₂). Excess capacity is one of the main arguments that is used for the social cost of monopolistic competition. In a way, what we have here is a trade-off between higher average total costs and higher product diversity.

Monopolistic competition, in the long run, is dominated by zero-profit equilibrium, as any deviation from zero profit will cause firms to enter or exit the market. In some markets, there may be excess capacity as a by-product of a monopolistic competitive structure.