Read this chapter to learn about monopolistic competition. Make sure to distinguish the short-run from the long-run model.
In the long run, firms in monopolistic competitive markets are highly inefficient and can only break even.
Explain the concept of the long run and how it applies to a firms in monopolistic competition
In terms of production and supply, the "long-run" is the time period when there is no factor that is fixed and all aspects of production are variable and can therefore be adjusted to meet shifts in demand. Given a long enough time period, a firm can take the following actions in response to shifts in demand:
In the long-run, a monopolistically competitive market is inefficient. It achieves neither allocative nor productive efficiency. Also, since a monopolistic competitive firm has power over the market that is similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus.
Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.
While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. The decrease in demand and increase in cost causes the long run average cost curve to become tangent to the demand curve at the good’s profit maximizing price. This means two things. First, that the firms in a monopolistic competitive market will produce a surplus in the long run. Second, the firm will only be able to break even in the long-run; it will not be able to earn an economic profit.
Long Run Equilibrium of Monopolistic Competition: In the long run, a firm in a monopolistic competitive market will product the amount of goods where the long run marginal cost (LRMC) curve intersects marginal revenue (MR). The price will be set where the quantity produced falls on the average revenue (AR) curve. The result is that in the long-term the firm will break even.