Is Monopolistic Competition Inefficient?

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 gallon. But there is a drawback: motorists 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.

Quick Review

  • In the long-run equilibrium of a monopolistically competitive industry, there are many firms, each earning zero profit.

  • Price exceeds marginal cost, so some mutually beneficial trades are unexploited.

  • Monopolistically competitive firms have excess capacity because they do not minimize average total cost. But it is not clear that this is actually a source of inefficiency since consumers gain from product diversity.

15-3

  1. Question 15.5

    True or false? Explain your answers.

    1. Like a firm in a perfectly competitive industry, a firm in a monopolistically competitive industry is willing to sell a good at any price that equals or exceeds marginal cost.

    2. Suppose there is a monopolistically competitive industry in long-run equilibrium that possesses excess capacity. All the firms in the industry would be better off if they merged into a single firm and produced a single product, but whether consumers are made better off by this is ambiguous.

    3. Fads and fashions are more likely to arise in monopolistic competition or oligopoly than in monopoly or perfect competition.

Solutions appear at back of book.