Questions: Monopolistic Competition: Equilibrium and Product Differentiation

Question 1

A restaurant in a monopolistically competitive market is earning positive economic profit in the short run. What does long-run theory predict will happen?

• A. Other restaurants will enter with similar offerings, the firm's demand curve shifts rightward, and profits grow further
• B. Other restaurants will enter with differentiated alternatives, shifting the firm's demand curve leftward until profit falls to zero
• C. The firm will raise prices to sustain its profit margin, since it has pricing power as a differentiated producer
• D. Nothing — like a monopolist, a firm in monopolistic competition can sustain positive economic profit in the long run

Answer: (B)

Free entry is the mechanism that erodes profit in monopolistic competition. Unlike a monopoly with blocked entry, this market allows new entrants with their own differentiated products. Each new entrant captures some demand from existing firms, shifting their demand curves leftward and making them more elastic. The process continues until the demand curve is tangent to ATC, profit is zero, and no further entry is profitable. Option D is the key misconception — students sometimes conflate pricing power (which firms do have) with long-run profitability (which is competed away by entry).

Question 2

At the long-run equilibrium of a monopolistically competitive firm, the firm produces:

• A. At the minimum of its ATC curve, achieving productive efficiency like a perfectly competitive firm in the long run
• B. On the downward-sloping portion of its ATC curve, to the left of minimum ATC
• C. At the quantity where price equals marginal cost, so there is no deadweight loss
• D. At the minimum of its marginal cost curve, balancing the cost of differentiation against productive efficiency

Answer: (B)

The tangency condition forces the long-run equilibrium onto the downward-sloping part of ATC. Because the demand curve slopes downward (not horizontal like in perfect competition), it can only be tangent to ATC at a point where both curves are falling — which is always left of minimum ATC. Option A describes perfect competition, where the horizontal demand curve is tangent to ATC exactly at its minimum. Option C is wrong: P > MC at the monopolistic competition tangency point (the demand curve lies above the MR curve), so there is deadweight loss even at zero profit.

Question 3

In monopolistic competition long-run equilibrium, a firm charges a price above marginal cost even though economic profit is zero.

• T. True
• F. False

Answer: True

This is one of the most important features of the monopolistic competition equilibrium. Zero profit requires P = ATC (price covers average cost), but the firm still sets MR = MC to maximize profit. At the tangency point, P > MR = MC, because the downward-sloping demand curve always lies above its corresponding MR curve. So the firm simultaneously earns zero economic profit (P = ATC) and charges above marginal cost (P > MC). This distinguishes it from perfect competition, where long-run equilibrium has P = MC = ATC (minimum).

Question 4

Excess capacity in monopolistic competition long-run equilibrium exists for the same reason as in monopoly — barriers to entry prevent competition from pushing firms to efficient scale.

• T. True
• F. False

Answer: False

This conflates two distinct sources of inefficiency. In monopoly, barriers to entry allow the firm to sustain P > ATC and produce below efficient scale indefinitely. In monopolistic competition, entry is free — the excess capacity arises from the tangency condition itself. Because the demand curve slopes downward, it can only be tangent to ATC to the left of minimum ATC. Excess capacity here is the cost of product variety: each firm produces a differentiated product that consumers value, but each operates at a scale below the cost-minimizing output. More entry means more variety and more excess capacity, not a remedy for it.

Question 5

Explain what 'excess capacity' means in monopolistic competition long-run equilibrium and why it exists even when economic profit is zero.

Model answer: Excess capacity means each firm produces less than the output that would minimize its average total cost. At the tangency point (P = ATC), the demand curve touches the ATC curve on the downward-sloping portion — to the left of minimum ATC. The firm could lower average cost by expanding output, but its downward-sloping demand curve means it would have to lower price to sell more, and the new price would fall below ATC, producing a loss. So it stays at the tangency point: zero profit, but inefficiently small scale. This excess capacity exists precisely because differentiation gives each firm a downward-sloping demand curve rather than the horizontal demand curve of perfect competition.

The key insight is that excess capacity and zero profit are jointly determined by the tangency condition, not contradictory. The 'wasted' capacity is the economic cost of product differentiation — consumers get variety they value, but each variety is produced at above-minimum cost. Whether this tradeoff is welfare-improving depends on how much consumers value variety, which is why economists debate the welfare implications of monopolistic competition.