Suppose an industry is monopolistically competitive: it consists of many producers, all competing for the same consumers but offering differentiated products. How does such an industry behave?

As the term monopolistic competition suggests, this market structure combines some features typical of monopoly with others typical of perfect competition. Because each firm is offering a distinct product, it is in a way like a monopolist: it faces a downward-sloping demand curve and has some market power—the ability within limits to determine the price of its product. However, unlike a pure monopolist, a monopolistically competitive firm does face competition: the amount of its product it can sell depends on the prices and products offered by other firms in the industry.

The same, of course, is true of an oligopoly. In a monopolistically competitive industry, however, there are many producers, as opposed to the small number that defines an oligopoly. This means that the “puzzle” of oligopoly—will firms collude or will they behave noncooperatively?—does not arise in the case of monopolistically competitive industries. True, if all the gas stations or all the restaurants in a town could agree—explicitly or tacitly—to raise prices, it would be in their mutual interest to do so.

But such collusion is virtually impossible when the number of firms is large and, by implication, there are no barriers to entry. So in situations of monopolistic competition, we can safely assume that firms behave noncooperatively and ignore the potential for collusion.

We introduced the distinction between short-run and long-run equilibrium back in Chapter 12. The short-run equilibrium of an industry takes the number of firms as given. The long-run equilibrium, by contrast, is reached only after enough time has elapsed for firms to enter or exit the industry. To analyze monopolistic competition, we focus first on the short run and then on how an industry moves from the short run to the long run.

Panels (a) and (b) of Figure 15-1 show two possible situations that a typical firm in a monopolistically competitive industry might face in the short run. In each case, the firm looks like any monopolist: it faces a downward-sloping demand curve, which implies a downward-sloping marginal revenue curve.

We assume that every firm has an upward-sloping marginal cost curve but that it also faces some fixed costs, so that its average total cost curve is U-shaped. This assumption doesn’t matter in the short run, but, as we’ll see shortly, it is crucial to understanding the long-run equilibrium.

In each case the firm, in order to maximize profit, sets marginal revenue equal to marginal cost. So how do these two figures differ? In panel (a) the firm is profitable; in panel (b) it is unprofitable. (Recall that we are referring always to economic profit, not accounting profit—that is, a profit given that all factors of production are earning their opportunity costs.)

In panel (a) the firm faces the demand curve D_P and the marginal revenue curve MR_P. It produces the profit-maximizing output Q_P, the quantity at which marginal revenue is equal to marginal cost, and sells it at the price P_P. This price is above the average total cost at this output, ATC_P. The firm’s profit is indicated by the area of the shaded rectangle.

In panel (b) the firm faces the demand curve D_U and the marginal revenue curve MR_U. It chooses the quantity Q_U at which marginal revenue is equal to marginal cost. However, in this case the price P_U is below the average total cost ATC_U; so at this quantity the firm loses money. Its loss is equal to the area of the shaded rectangle. Since Q_U is the profit-maximizing quantity—which means, in this case, the loss-minimizing quantity—there is no way for a firm in this situation to make a profit. We can confirm this by noting that at any quantity of output, the average total cost curve in panel (b) lies above the demand curve D_U. Because ATC > P at all quantities of output, this firm always suffers a loss.

As this comparison suggests, the key to whether a firm with market power is profitable or unprofitable in the short run lies in the relationship between its demand curve and its average total cost curve. In panel (a) the demand curve D_P crosses the average total cost curve, meaning that some of the demand curve lies above the average total cost curve. So there are some price-quantity combinations available at which price is higher than average total cost, indicating that the firm can choose a quantity at which it makes positive profit.

In panel (b), by contrast, the demand curve D_U does not cross the average total cost curve—it always lies below it. So the price corresponding to each quantity demanded is always less than the average total cost of producing that quantity. There is no quantity at which the firm can avoid losing money.

These figures, showing firms facing downward-sloping demand curves and their associated marginal revenue curves, look just like ordinary monopoly analysis. The “competition” aspect of monopolistic competition comes into play, however, when we move from the short run to the long run.

Obviously, an industry in which existing firms are losing money, like the one in panel (b) of Figure 15-1, is not in long-run equilibrium. When existing firms are losing money, some firms will exit the industry. The industry will not be in long-run equilibrium until the persistent losses have been eliminated by the exit of some firms.

It may be less obvious that an industry in which existing firms are earning profits, like the one in panel (a) of Figure 15-1, is also not in long-run equilibrium. Given that there is free entry into the industry, persistent profits earned by the existing firms will lead to the entry of additional producers. The industry will not be in long-run equilibrium until the persistent profits have been eliminated by the entry of new producers.

How will entry or exit by other firms affect the profits of a typical existing firm? Because the differentiated products offered by firms in a monopolistically competitive industry compete for the same set of customers, entry or exit by other firms will affect the demand curve facing every existing producer. If new gas stations open along a highway, each of the existing gas stations will no longer be able to sell as much gas as before at any given price. So, as illustrated in panel (a) of Figure 15-2, entry of additional producers into a monopolistically competitive industry will lead to a leftward shift of the demand curve and the marginal revenue curve facing a typical existing producer.

Conversely, suppose that some of the gas stations along the highway close. Then each of the remaining stations will be able to sell more gasoline at any given price. So, as illustrated in panel (b), exit of firms from an industry will lead to a rightward shift of the demand curve and marginal revenue curve facing a typical remaining producer.

The industry will be in long-run equilibrium when there is neither entry nor exit. This will occur only when every firm earns zero profit. So in the long run, a monopolistically competitive industry will end up in zero-profit equilibrium, in which firms just manage to cover their costs at their profit-maximizing output quantities.

We have seen that a firm facing a downward-sloping demand curve will earn positive profits if any part of that demand curve lies above its average total cost curve; it will incur a loss if its demand curve lies everywhere below its average total cost curve. So in zero-profit equilibrium, the firm must be in a borderline position between these two cases; its demand curve must just touch its average total cost curve. That is, it must be just tangent to it at the firm’s profit-maximizing output quantity—the output quantity at which marginal revenue equals marginal cost.

If this is not the case, the firm operating at its profit-maximizing quantity will find itself making either a profit or loss, as illustrated in the panels of Figure 15-1. But we also know that free entry and exit means that this cannot be a long-run equilibrium. Why? In the case of a profit, new firms will enter the industry, shifting the demand curve of every existing firm leftward until all profits are extinguished. In the case of a loss, some existing firms will exit and so shift the demand curve of every remaining firm to the right until all losses are extinguished. All entry and exit ceases only when every existing firm makes zero profit at its profit-maximizing quantity of output.

Figure 15-3 shows a typical monopolistically competitive firm in such a zero-profit equilibrium. The firm produces Q_MC, the output at which MR_MC = MC, and charges price P_UE. At this price and quantity, represented by point Z, the demand curve is just tangent to its average total cost curve. The firm earns zero profit because price, P_UE, is equal to average total cost, ATC_MC.

The normal long-run condition of a monopolistically competitive industry, then, is that each producer is in the situation shown in Figure 15-3. Each producer acts like a monopolist, facing a downward-sloping demand curve and setting marginal cost equal to marginal revenue so as to maximize profits. But this is just enough to achieve zero economic profit. The producers in the industry are like monopolists without monopoly profits.