In a way, long-run equilibrium in a monopolistically competitive industry looks a lot like long-run equilibrium in a perfectly competitive industry. In both cases, there are many firms; in both cases, profits have been competed away; in both cases, the price received by every firm is equal to the average total cost of production.

However, the two versions of long-run equilibrium are different—in ways that are economically significant.

Figure 15-4 compares the long-run equilibrium of a typical firm in a perfectly competitive industry with that of a typical firm in a monopolistically competitive industry. Panel (a) shows a perfectly competitive firm facing a market price equal to its minimum average total cost; panel (b) reproduces Figure 15-3. Comparing the panels, we see two important differences.

First, in the case of the perfectly competitive firm shown in panel (a), the price, P_PC, received by the firm at the profit-maximizing quantity, q_PC, is equal to the firm’s marginal cost of production, MC_PC, at that quantity of output. By contrast, at the profit-maximizing quantity chosen by the monopolistically competitive firm in panel (b), q_MC, the price, P_MC, is higher than the marginal cost of production, MC_MC.

This difference translates into a difference in the attitude of firms toward consumers. A wheat farmer, who can sell as much wheat as he likes at the going market price, would not get particularly excited if you offered to buy some more wheat at the market price. Since he has no desire to produce more at that price and can sell the wheat to someone else, you are not doing him a favour.

But if you decide to fill up your tank at Jamil’s gas station rather than at Katy’s, you are doing Jamil a favour. He is not willing to cut his price to get more customers—he’s already made the best of that trade-off. But if he gets a few more customers than he expected at the posted price, that’s good news: an additional sale at the posted price increases his revenue more than it increases his costs because the posted price exceeds marginal cost.

The fact that monopolistic competitors, unlike perfect competitors, want to sell more at the going price is crucial to understanding why they engage in activities like advertising that help increase sales.

The other difference between monopolistic competition and perfect competition that is visible in Figure 15-4 involves the position of each firm on its average total cost curve. In panel (a), the perfectly competitive firm produces at point q_PC, at the bottom of the U-shaped ATC curve. That is, each firm produces the quantity at which average total cost is minimized—the minimum-cost output. As a consequence, the total cost of industry output is also minimized.

Under monopolistic competition, in panel (b), the firm produces at q_MC, on the downward-sloping part of the U-shaped ATC curve: it produces less than the quantity that would minimize average total cost. This failure to produce enough to minimize average total cost is sometimes described as the excess capacity issue. The typical vendor in a food court or gas station along a road is not big enough to take maximum advantage of available cost savings. So the total cost of industry output is not minimized in the case of a monopolistically competitive industry.

Some people have argued that, because every monopolistic competitor has excess capacity, monopolistically competitive industries are inefficient. But the issue of efficiency under monopolistic competition turns out to be a subtle one that does not have a clear answer.

A monopolistic competitor, like a monopolist, charges a price that is above marginal cost. As a result, some people who are willing to pay at least as much for an egg roll at Wonderful Wok as it costs to produce it are deterred from doing so. In monopolistic competition, some mutually beneficial transactions go unexploited.

Furthermore, it is often argued that monopolistic competition is subject to a further kind of inefficiency: that the excess capacity of every monopolistic competitor implies wasteful duplication because monopolistically competitive industries offer too many varieties. According to this argument, it would be better if there were only two or three vendors in the food court, not six or seven. If there were fewer vendors, they would each have lower average total costs and so could offer food more cheaply.

Is this argument against monopolistic competition right—that it lowers total surplus by causing inefficiency? Not necessarily. It’s true that if there were fewer gas stations along a highway, each gas station would sell more gasoline and so would have lower costs per litre. But there is a drawback: drivers would be inconvenienced because gas stations would be farther apart. The point is that the diversity of products offered in a monopolistically competitive industry is beneficial to consumers. So the higher price consumers pay because of excess capacity is offset to some extent by the value they receive from greater diversity.

There is, in other words, a trade-off: more producers means higher average total costs but also greater product diversity. Does a monopolistically competitive industry arrive at the socially optimal point on this trade-off? Probably not—but it is hard to say whether there are too many firms or too few! Most economists now believe that duplication of effort and excess capacity in monopolistically competitive industries are not important issues in practice.