Summary
Highlights
Monopolistic competition involves many firms and consumers, but firms sell slightly differentiated goods (e.g., tennis shoe brands). This differentiation gives each firm some market power, allowing them to be price setters, unlike perfect competition where goods are identical and firms are price takers.
In the short run, a monopolistically competitive firm faces a downward-sloping demand curve and a marginal revenue curve below it. The optimal quantity is determined where marginal revenue equals marginal cost, and the price is then set by the demand curve at that quantity. If the price is above the average total cost, the firm makes a positive profit.
Because there are no barriers to entry in monopolistic competition, positive short-run profits attract new firms. This entry shifts the demand curve for existing firms downwards, along with their marginal revenue curve. This process continues until the demand curve becomes tangent to the average total cost curve, leading to zero economic profits in the long run.
In the long run, even with zero economic profits, monopolistic competition results in two inefficiencies: firms do not produce at their efficient scale (minimizing average total cost), and the price is above marginal cost, which means they produce less and charge more than what would be socially optimal compared to perfect competition.