Imperfect Competition / Monopolistic Competition

An imperfectly competitive industry consists of large numbers of firms each facing a downward sloping demand curve for its goods or services. Firms have a degree of control over price, possibly because there are real or imagined differences between their products and those of competitors, due to elements of local monopoly like the corner grocery store being more convenient to consumers who live nearby, or perhaps for other reasons. The more these factors exist, the more inelastic the firm’s demand curve will be. In the case of a corner store, if they increase prices they will certainly lose some business, but some people will continue to pay the higher price because of the time and inconvenience involved in going “into town.”

Since each firm faces a downward sloping demand curve, average revenue and marginal revenue will diverge, as they do under a monopoly, but by much less. Again as with a monopoly, firms will expand or contract output so that MC=MR. But since the demand curve (AR) is greater than MR, above normal profits will be earned. This will provide an incentive for new firms to move into the industry. Assuming factor prices remain constant, the demand curve of existing firms will shift to the left until, in long run equilibrium, the firm’s demand curve is tangential to its average cost curve (AR < ATC for all points except one where AR=ATC, which also happens to be the quantity where MR=MC). Normal profit is thus earned.

However, the point where AR=ATC is not the point of minimum ATC. A monopolistic competitor in long-term equilibrium produces at a quantity where ATC is higher than minimum, or in other words where spare capacity exists. At the same time, price is higher than MC, so economic inefficiency results. If the firm were to produce at minimum ATC, at which point price would equal MC since MC intersects ATC at the minimum point, ATC would be higher than AR and the firm would incur a loss. There is therefore no incentive for firms to produce beyond the point where AR=ATC (and MR=MC).

The implication of imperfect competition is that spare capacity exists and this produces economic inefficiency, even though above normal profits are not being earned. This inefficiency must be set against the product differentiation which such firms provide society.