CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 1

CHAPTER 7 | Market Structures:

Firms in Perfectly Competitive Markets & Monopolistic
Competition

Chapter Outline

7.1 Perfectly Competitive Markets

Explain what a perfectly competitive market is and why a perfect competitor
faces a horizontal demand curve.
 The three conditions that make a market perfectly competitive are: there
are many buyers and sellers, all firms sell identical products, and there are
no barriers to new firms entering the market.

7.2 How a Firm Maximizes Profit in a Perfectly Competitive Market

Explain how a firm maximizes profit in a perfectly competitive market.
 To maximize profit, the firm produces an output where the difference
between total revenue and total cost is as large as possible.

7.3 Illustrating Profit or Loss on the Cost Curve Graph

Use graphs to show a firm’s profit or loss.
 Whether the firm will earn a profit depends on the relationship between its
price (P) and average total cost (ATC).

7.4 Deciding Whether to Produce or to Shut Down in the Short Run

Explain why firms may shut down temporarily.
 In the short run, a firm experiencing a loss can continue to produce or stop
production by shutting down temporarily.

7.5 “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of
Firms in the Long Run
Explain how entry and exit ensure that perfectly competitive firms earn zero
economic profit in the long run.
 If firms earn economic profits in the short run, other firms will enter the
market. If firms suffer losses in the short run, some firms will exit the
market. In the long run, entry and exit result in the typical firm breaking
even.

7.6 Perfect Competition and Efficiency

Explain how perfect competition leads to economic efficiency.
 Perfect competition results in productive efficiency and allocative
efficiency.

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 2

Perfect Competition in Farmers’ Markets

In recent years, the demand for healthier food has increased. Many people have begun
buying fruits and vegetables at farmers’ markets. Lured by higher profits, increasing
numbers of farmers began participating in these markets. But the additional supply of
produce has forced down prices and reduced profits. Many farmers have found that the
profits they earn from selling in farmers’ markets are no longer higher than what they
earn selling to supermarkets.

Perfectly Competitive Markets

7.1 Learning Objective: Explain what a perfectly competitive market is and why a
perfect competitor faces a horizontal demand curve.

A perfectly competitive market is a market that meets the conditions of (1) many
buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new
firms entering the market. Firms in perfectly competitive markets are unable to affect the
prices of the goods they sell and are unable earn economic profits in the long run.

A. A Perfectly Competitive Firm Cannot Affect the Market Price

Prices in perfectly competitive markets are determined by the intersection of market
demand and supply curves. Consumers and firms must accept the market price if
they want to buy and sell in a competitive market. A price taker is a buyer or seller
that is unable to affect the market price. Each buyer and seller in a perfectly
competitive market is too small to affect the market price.

B. The Demand Curve for the Output of a Perfectly Competitive Firm

Because the firm is a price taker, it can sell as much output as it wants at the market
price. Although the market demand curve has the normal downward shape, the
demand curve for a perfectly competitive firm is horizontal at the market price.

7.1.1 Perfectly competitive markets share three characteristics: 1) there are many
buyers and sellers, 2) all firms are selling identical products, and 3) there are no
barriers to firms entering the market.

7.1.2 A price taker is a buyer or seller that is unable to affect the market price. Because
a firm in a perfectly competitive market is very small relative to the market, and
because it is selling exactly the same product as every other firm, it can sell as
much as it wants without having to lower its price. If the firm raises its price, the
firm will sell nothing.

7.1.3 The graph will look like Figure 12.2. Please refer to the PPT slide 7.

The graph on the left shows the market supply and demand curve for corn. The graph on
the right shows the demand for corn produced by one corn farmer.

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 3

7.2 How a Firm Maximizes Profit in a Perfectly Competitive Market

Learning Objective: Explain how a firm maximizes profit in a perfectly
competitive market.

It is reasonable to assume that the objective of a producer is to maximize profit, which

is equal to total revenue (TR) minus total cost (TC). To maximize profit, a firm must
produce that quantity of output where the difference between TR and TC is as large as
possible.

A. Revenue for a Firm in a Perfectly Competitive Market

A firm’s average revenue (AR) is equal to total revenue divided by the quantity of
the product sold. Average revenue is also equal to the market price. Marginal
revenue (MR) is the change in total revenue from selling one more unit of a product.
For a firm in a perfectly competitive market, price is equal to both average revenue
and marginal revenue.

B. Determining the Profit-Maximizing Level of Output

The marginal revenue curve for a perfectly competitive firm is the same as its
demand curve. As long as marginal revenue is greater than marginal cost, the firm’s
profits are increasing, and it will expand production. When marginal revenue is equal
to marginal cost, the firm will make no additional profit by increasing production, so it
will have maximized its profits. The profit-maximizing level of output is also where
the difference between total revenue and total cost is the greatest. Because price is
equal to marginal revenue for a perfectly competitive firm, price equals marginal cost
at the profit-maximizing level of output.

Normal return is included in the cost of production, so that the revenue earned from the
profit-maximizing unit of output is just enough to compensate the firm’s owner(s) for the
opportunity cost of their investment in the firm.

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 4

7.2.1 A firm in a perfectly competitive market is a price taker and can sell as many
units as it wishes at the market price P. By selling an additional unit, the firm receives
additional (or marginal) revenue of P. Because each unit is sold at P, the average
revenue will also equal P, and we get the result P = MR = AR.

7.2.2 As long as MR > MC, a firm should continue to expand production because doing
so adds more to its total revenue than to its total cost, thereby increasing total
profit. When a firm reaches the level of output at which marginal revenue equals
marginal cost, it has reached the point where producing that unit of output will
add as much to its total revenue as it does to its total cost, which means that total
profit cannot get be increased and therefore must be at a maximum.

7.2.3 In a perfectly competitive market, MR = P, making these two conditions

equivalent.

7.2.4 A firm maximizes profits by selling where marginal revenue is equal to marginal
cost. If a firm stops producing where marginal revenue is greater than marginal
cost, then it could increase its profits by producing more. Firms are not interested
in maximizing their profits per unit sold. Firms are interested in maximizing their
total profits.

7.2.5 Revenue is just the total dollar amount of a firm’s sales. Firms are interested in
what they have left over from their revenues after they have paid all of the costs of
producing the goods they sell. Profit is what’s left over when you subtract total cost
from total revenue. That is why firms maximize profit, rather than revenue. A
revenue-maximizing firm is likely to produce more output than if it were maximizing
profit because revenues tend to increase past the point where profits start to
decline.

Illustrating Profit or Loss on the Cost Curve Graph (pages 403–407)

7.3
Learning Objective: Use graphs to show a firm’s profit or loss.

Profit can be expressed in terms of average total cost (ATC). Doing so will allow us to
show profit on a cost curve graph. Because profit equals TR minus TC, and TR is price
multiplied by quantity:

Profit = (P × Q) – TC.

If we divide both sides of this equation by Q, we have:

or

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 5

This equation tells us that profit per unit equals price minus average total cost. We
obtain the expression for the relationship between total profit and average total cost by
multiplying through by Q:

Profit = (P – ATC) × Q.

This equation tells us that a firm’s total profit is equal to the quantity produced multiplied
by the difference between price and average total cost.

A. Showing a Profit on the Graph

In a graph, the firm’s profit is equal to the area of a rectangle with a height of (P –
ATC) and a base equal to Q.

B. Illustrating When a Firm Is Breaking Even or Operating at a Loss

Whether a firm makes a profit depends on the relationship of price to average total
cost. There are three possibilities: (1) P > ATC, which means the firm makes a profit;
(2) P = ATC, which means the firm breaks even; and (3) P < ATC, which means the
firm experiences losses.

1. If the ATC curve crosses the firm’s demand curve, price must exceed ATC at the
level of output where profit is maximized.
2. To illustrate a firm suffering losses, the ATC curve is drawn so that it is above the
demand curve for every level of output.
3. Always draw the demand curve and the MC curve first to determine the profit-
maximizing output. This will make it easier to identify ATC and AVC at this same
output.

7.4 Deciding Whether to Produce or to Shut Down in the Short Run

Learning Objective: Explain why firms may shut down temporarily.

In the short run, a firm suffering losses has two choices: (1) Continue to produce or (2)
stop production by shutting down temporarily. During a temporary shutdown, a firm must
still pay its fixed costs. If by producing the firm would lose an amount greater than its
fixed costs, it should shut down. In analyzing the firm’s decision to shut down, we
assume that its fixed costs are sunk costs.

A sunk cost is a cost that has already been paid and cannot be recovered. The firm
should treat its sunk costs as irrelevant to its decision making. One option the firm does
not have is to raise its price. If a perfectly competitive firm raises its price, it would lose
all its customers and sales would drop to zero.

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 6

A. The Supply Curve of a Firm in the Short Run

If the price the firm can charge drops below average variable cost, the firm will have
a smaller loss if it shuts down and produces no output. So, the firm’s marginal cost
curve is its supply curve for prices at or above average variable cost. Because the
marginal cost curve intersects the average variable cost curve where the average
cost curve is at its minimum point, the firm’s supply curve is its marginal cost curve
above the minimum point of the average variable cost curve.

The shutdown point is the minimum point on a firm's average variable cost curve.
If the price falls below this point, the firm shuts down production in the short run.

B. The Market Supply Curve in a Perfectly Competitive Industry

The market supply curve in a perfectly competitive industry is determined by adding
up the quantity supplied by each firm in the market at each price.

Should not be confused with the decision to shut down with the decision to go out of
business. Many firms that shut down sell goods or services only in certain seasons.
Examples include ski resorts, retail stores near summer resorts, and Christmas tree
vendors

7.4.1 In the short run, a firm will shut down if the price falls below the minimum point on
its average variable cost curve.

In the long run, a firm will shut down (and exit the industry) if the price is below
the minimum point on its average total cost curve. In the short run, the firm is
willing to accept losses, because it cannot do anything about its fixed costs—and
must pay them whether or not it is producing anything. In the long run, however,
the firm can exit the industry if it expects continued losses.

7.4.2 The perfectly competitive firm’s supply curve can be directly derived from its
marginal cost curve. The firm will produce where P = MC if price is at or above the
shutdown point at the minimum of AVC.

7.4.3 The market supply curve is determined by adding up the quantity supplied (using
the marginal cost curves) by each firm in the market at each price.

7.5 “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit
of Firms in the Long Run
Learning Objective: Explain how entry and exit ensure that perfectly
competitive firms earn zero economic profit in the long run.

In the long run, unless a firm can cover all of its costs, it will shut down and exit the
industry.

A. Economic Profit and the Entry or Exit Decision

Economic profit is equal to a firm’s revenues minus all its costs, implicit and

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 7

explicit. A firm is unlikely to earn an economic profit for very long. Other firms that
are just breaking even have an incentive to enter the market so they can earn
economic profits. The more firms there are in an industry, the further to the right is
the market supply curve. Entry into the market will continue until all firms are just
breaking even. Firms can suffer economic losses in the short run. An economic
loss is the situation in which a firm’s total revenue is less than its total cost, including
all implicit costs. As long as price is above average variable cost, a firm suffering a
loss will continue to produce in the short run. But in the long run, firms will exit an
industry if they are unable to cover all their costs.

B. Long-Run Equilibrium in a Perfectly Competitive Market

Economic profits attract firms to enter an industry. The entry of firms forces down the
market price until the typical firm is breaking even. Economic losses cause firms to
exit an industry. The exit of firms raises the market price until the typical firm is
breaking even. This process results in a long-run competitive equilibrium. Long-run
competitive equilibrium is the situation in which the entry and exit of firms has
resulted in the typical firm breaking even. The long-run equilibrium price is at a level
equal to the minimum point on the typical firm’s average total cost curve.

C. The Long-Run Supply Curve in a Perfectly Competitive Market

The long-run supply curve is a curve that shows the relationship in the long run
between market price and the quantity supplied. In the long run, a perfectly
competitive market will supply whatever amount of a good consumers demand at a
price determined by the minimum point on the typical firm’s average total cost curve.

D. Increasing-Cost and Decreasing-Cost Industries

Any industry in which the typical firm’s average costs do not change as the industry
expands production will have a horizontal long-run cost curve. Industries where this
result holds true are called constant-cost industries. If an input used in producing a
good is available in only limited quantities, the cost of the input will rise as the
industry expands. In this case, the long-run supply curve will slope upward.
Industries with upward-sloping long-run supply curves are called increasing-cost
industries. In some cases, the typical firm’s average costs fall as the industry
expands, and the long-run supply curve will slope downward. Industries with
downward-sloping long-run supply curves are called decreasing-cost industries.

7.5.1 Economic profits lead firms to enter an industry. Economic losses lead firms to
exit an industry.

7.5.2 A firm earning zero economic profit would continue to produce, even in the long
run, because it is earning as much as it would earn elsewhere—it is earning the
average rate of return on its investment.

7.5.3 The long-run supply curve in a perfectly competitive market will be a horizontal
line if it is a constant-cost industry—that is, if the typical firm’s average cost
curves are unchanged as the industry expands or contracts. If the firm is an
increasing-cost industry, the long-run supply curve will slope upward; if the firm is

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a decreasing-cost industry, the long-run supply curve will slope downward.

7.5.4 In the graph on the left, the increase in the demand for laptop computers causes
the demand curve to shift from D1 to D2, temporarily driving the price up to P3. As
the production of laptops increases, more orders are placed for laptop displays.
As production of laptop displays increases, their cost and price fall because of
economies of scale. As shown in the graph on the right, with increased demand
and lower costs, the firms that assemble laptops can make economic profits at
P3. The result is that new firms enter the industry, the industry supply curve shifts
from S1 to S2, driving down the price to P2 and eliminating economic profits.
Because the price of laptop computers declines as output increases, the long-run
supply curve is downward sloping. This is a decreasing-cost industry.

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Perfect Competition and Efficiency

7.6
Learning Objective: Explain how perfect competition leads to economic efficiency.

A. Productive Efficiency
In a market system, consumers get as many apples as they want, produced at the
lowest average cost possible. The forces of competition will drive the market price to
the minimum average cost of the typical firm. Productive efficiency is the situation
in which a good or service is produced at the lowest possible cost. Managers of
firms strive to earn an economic profit by reducing costs. But in a perfectly
competitive market, other firms quickly copy ways of reducing costs, so that in the
long run only consumers benefit from cost reductions.

B. Allocative Efficiency
Competitive firms not only produce goods and services at the lowest possible cost,
they also produce the goods and services that consumers value most. Perfect
competition achieves allocative efficiency, a state of the economy in which
production represents consumer preferences; in particular, every good or service is
produced up to the point where the last unit provides a marginal benefit to
consumers equal to the marginal cost of producing it. Productive efficiency and
allocative efficiency are useful benchmarks against which to compare the actual
performance of the economy.

Critics of the perfectly competitive model complain that few industries feature buyers
and sellers of identical products made by firms that are all price takers. This criticism
fails to recognize what an economic model is and how models are used by economists.

Although not perfectly competitive, many markets are very competitive and experience
entry and exit in response to short-run profits and losses. The markets for televisions,
calculators, personal computers, and automobiles have changed over time as firms
earned short-run profits or new technologies forced firms to adapt. The steel and coal
industries experienced exit by firms in response to short-run losses, much as the model
of perfect competition predicts.

7.6.1 If consumers want more of a product, the market will supply it. This increase in
production stems from the increase in demand, which results in higher prices and
firms earning economic profits. If consumers want less of a product, the market
will reduce its supply of the product. A decline in demand leads to lower prices
and firms suffering economics losses. As some firms exit the industry, the
quantity of the good supplied decreases. In this way, consumers are able to
dictate to firms the quantities of each good or service the firms produce.

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7.6.2 Allocative efficiency is the state of the economy in which production reflects
consumer preferences; in particular, every good or service is produced up to the
point where the last unit provides a marginal benefit to consumers equal to the
marginal cost of producing it. Productive efficiency is the situation in which a
good or service is produced at the lowest possible average cost. Productive
efficiency deals with how a good or service is produced, while allocative
efficiency deals with producing the goods and services that consumers value
most.

7.6.3 Consumers purchase output up to the point where price equals marginal benefit.
Under perfect competition, firms produce up to the point where price equals
marginal cost. Under perfect competition, therefore, we get an equilibrium
output where marginal benefit equals marginal cost, which represents allocative
efficiency. In a perfectly competitive industry, free entry and exit ensures that
in the long run firms are producing where average costs are minimized, thereby
ensuring that productive efficiency is also achieved.

7.6.4 As long as it is possible for firms to enter the industry, when firms earn a profit in
the long run new firms will enter the industry. New firms entering the industry will
cause the supply curve to shift to the right, which will lower prices and eliminate
economic profits. In the long run, even without a law being passed, prices will be
exactly equal to the average total cost of production, which means that firms will
be breaking even.

Monopolistic Competition: The Competitive Model in a More Realistic Setting

Unit Outline

7.1 Demand and Marginal Revenue for a Firm in a Monopolistically Competitive

Market
Explain why a monopolistically competitive firm has downward-sloping demand
and marginal revenue curves.
 A monopolistically competitive firm must cut its price to sell more, so its
marginal revenue curve will slope downward and will be below its demand
curve.

7.2 How a Monopolistically Competitive Firm Maximizes Profit in the Short Run
Explain how a monopolistically competitive firm maximizes profit in the short run.
 All firms maximize profits by producing where marginal revenue is equal to
marginal cost. A monopolistically competitive firm will maximize profits
where price is greater than marginal cost.

7.3 What Happens to Profits in the Long Run?

Analyze the situation of a monopolistically competitive firm in the long run.
 When a monopolistically competitive firm makes a short-run economic

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profit, entrepreneurs will enter the market, causing the firm’s demand
curve to shift to the left and become more elastic. In the long run, a
monopolistically competitive firm will break even.
 A monopolistically competitive firm may exit the industry if it suffers short-
run losses.

7.4 Comparing Monopolistic Competition and Perfect Competition

Compare the efficiency of monopolistic competition and perfect competition.
 Unlike perfectly competitive firms, monopolistically competitive firms
charge a price greater than marginal cost and do not produce at minimum
average total cost.

7.5 How Marketing Differentiates Products

Define marketing and explain how firms use marketing to differentiate their
products.
 Firms use two marketing tools to differentiate their products: brand
management and advertising.

7.6 What Makes a Firm Successful?

Identify the key factors that determine a firm’s success.
 A firm can be profitable if it can differentiate its product or if it can produce
its product at a lower average cost than competing firms.

7.1 Demand and Marginal Revenue for a Firm in a Monopolistically

Competitive Market.
Learning Objective: Explain why a monopolistically competitive firm has
downward-sloping demand and marginal revenue curves.

Monopolistic competition is a market structure in which barriers to entry are low, and
many firms compete by selling similar, but not identical, products.

A. The Demand Curve for a Monopolistically Competitive Firm

An increase in the price of a monopolistically competitive firm’s product reduces the
quantity sold.

B. Marginal Revenue for a Firm with a Downward-Sloping Demand Curve

When a firm cuts its price, one good thing happens: The firm will sell more, which is
called the output effect. But one bad thing happens when price is cut: The firm will
receive less revenue for each unit of output it could have sold at the higher price,
which is called the price effect. Every firm that has the ability to affect the price of the
good or service it sells will have a marginal revenue curve that is below its demand
curve. When the firm lowers its price, marginal revenue will be positive when the
additional revenue from selling one more unit of output is greater than the revenue
lost from receiving a lower price. Marginal revenue will be negative when the
additional revenue from selling one more unit of output is less than the revenue lost
from receiving a lower price.

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7.1.1 In both perfectly competitive and monopolistically competitive industries, there

are many firms and low barriers to entry. However, while products are identical in
perfectly competitive markets, products are similar—but not identical—in
monopolistically competitive markets. Wheat and many raw materials are sold in
perfectly competitive markets; haircuts and restaurant meals are sold in
monopolistically competitive markets.

7.1.2 The local McDonald’s faces a downward-sloping demand curve for Quarter
Pounders because if it increases its price, customers will substitute away from
Quarter Pounders and buy something else—like burgers at Wendy’s or Burger
King. If McDonald’s raises its prices, it won’t lose all of its customers, however,
because it is located more conveniently than other restaurants for some people
and some people strongly prefer Quarter Pounders to other similar products.

7.1.3 Average revenue is equal to total revenue divided by quantity. Because total
revenue is price times quantity, dividing by quantity leaves just price. So, average
revenue is equal to price. (Note that price equals average revenue for every
firm, not just for monopolistically competitive firms.) For any firm that is a price
setter, marginal revenue is less than price because when the firm lowers price to
sell an additional unit, it must lower the price on all units (not just the last unit).

7.2 How a Monopolistically Competitive Firm Maximizes Profit in the Short

Run
Learning Objective: Explain how a monopolistically competitive firm maximizes
profit in the short run.

All firms maximize their profits by producing where marginal revenue equals marginal
cost. Unlike a perfectly competitive firm, a monopolistically competitive firm will produce
where P > MC.

7.2.1 Because P > MR for a monopolistically competitive firm, a profit-maximizing

monopolistically competitive firm producing where MR = MC will necessarily
produce where P > MC.

7.2.2 Profit = Revenue – Cost = Quantity × (price – average cost)

7.2.3 Monopolistically competitive firms produce the level of output where marginal
revenue equals marginal cost. Because fixed costs have no effect on marginal
costs, monopolistically competitive firms can ignore them when deciding how
much to produce.

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The graph shows that when the marginal and average total cost curves shift up, the
profit-maximizing price rises from P1 to P2.

This is to illustrate that MC and ATC cost curves may shift as well. It will have an impact
on Production costs. For example, rental cost may increase by 20% and government
may levy welfare contributions for workers.

What Happens to Profits in the Long Run?

7.3 Learning Objective: Analyze the situation of a monopolistically competitive firm
in the long run.

A. How Does the Entry of New Firms Affect the Profits of Existing Firms?
When firms earn economic profits, entrepreneurs have an incentive to enter the
market and establish new firms. The demand curve of an established firm will shift to
the left and become more elastic. Eventually, the demand curve will shift until it is
tangent to the firm’s average total cost curve. A firm may suffer economic losses in
the short run. In the long run, firms will exit an industry if they suffer economic
losses. The exit of some firms will shift the demand curve for the output of a
remaining firm to the right. Eventually, the representative firm will charge a price
equal to average total cost and break even.

B. Is Zero Economic Profit Inevitable in the Long Run?

Owners do not have to accept breaking even. The key to earning economic profits is
to sell a differentiated product or to find a way to produce an existing product at a
lower cost. Firms continually struggle to find new ways to stay one step ahead of
other firms that attempt to copy their success.

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 14

7.3.1 New firms entering an industry cause the demand curves for the products of
existing firms to shift to the left. Existing firms will be able to sell less at every
price, so their profits will decline.

7.3.2 As more firms enter the industry, the existing firm’s demand curve shifts to the left
because the firm will sell fewer units of output when there are additional firms in
the area selling similar products. And the demand curve becomes more elastic
because consumers have additional firms from which to buy their products.

7.3.3 Economic profits take into account opportunity costs. Accounting profits do not. So,
economic profits will typically be smaller than accounting profits. If a firm has zero
accounting profits, it will be making an economic loss, while a firm with zero
economic profits will have positive accounting profits.

7.3.4 Although firms may initially continue to earn economic profits as new firms enter
the market, economic profits will become zero in the long run. Technological
advances and continuing differentiation of products may again result in positive
economic profits, but over time other firms will adjust and continued entry drives
economic profits to zero in the long run.

7.4 Comparing Monopolistic Competition and Perfect Competition

Learning Objective: Compare the efficiency of monopolistic competition and
perfect competition.

There are two important differences between long-run equilibrium in monopolistic

competition and perfect competition. Monopolistically competitive firms charge a price
greater than marginal cost and they do not produce at minimum average total cost.

A. Excess Capacity under Monopolistic Competition

Because a monopolistically competitive firm maximizes profit at an output level that
is not at the minimum point of its average total cost curve, it has excess capacity. If
the firm increased its output, it could produce at a lower average cost.

B. Is Monopolistic Competition Inefficient?

In a monopolistically competitive market neither productive efficiency nor allocative
efficiency are achieved. Economists have debated whether this results in a
significant loss of well-being to society in these markets compared with perfectly
competitive markets.

C. How Consumers Benefit from Monopolistic Competition

The demand curve for a monopolistically competitive firms slopes downward
because the good or service the firm is selling is differentiated from the goods or
services sold by competing firms. Firms differentiate their products to appeal to
consumers. When firms are successful in differentiating their products, this indicates
that some consumers find these products preferable to the alternatives. Consumers,
therefore, are better off than they would have been had these companies not

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differentiated their products. Consumers face a trade-off when buying the product of
a monopolistically competitive firm: Consumers pay a price greater than the marginal
cost, and the product is not produced at minimum average cost, but consumers
benefit from being able to purchase a product that is more closely suited to their
tastes.

Here is an example of consumers’ willingness to pay for greater convenience: Many

supermarkets open additional check-out lines—some for consumers that have just a
few items to buy—when long lines form. Most shoppers don’t mind paying somewhat
higher prices to avoid waiting in line.

7.4.1 In the long run, a perfectly competitive firm charges a price equal to marginal
cost and it produces the quantity that minimizes average total cost. A perfectly
competitive firm is allocatively and productively efficient. A monopolistically
competitive firm charges a price that is above marginal cost (so it is not
allocatively efficient), and it produces a quantity that is less than the amount that
minimizes average total cost (so it is not productively efficient). Despite these
differences, perfectly competitive and monopolistically competitive firms both
earn zero economic profits in the long run.

7.4.2 A monopolistically competitive firm is not productively efficient because it does

not produce at minimum average total cost. Excess capacity stems from the fact
that when a monopolistically competitive firm produces where MR = MC, it
produces a level of output that is below the quantity for which average total cost
is minimized.

7.4.3 A monopolistically competitive firm is not allocatively efficient because it charges

a price that is greater than marginal cost.

7.4.4 Monopolistic competition probably doesn’t cause a significant loss in economic

well-being to society. The loss or gain can be measured by total economic
surplus. Although monopolistically competitive firms reduce total economic
surplus by producing less than the efficient amount (creating a deadweight
loss), they also increase consumer surplus because people are willing to pay
more for variety and for products that are more closely suited to their tastes.

How Marketing Differentiates Products

7.5 Learning Objective: Define marketing and explain how firms use marketing to
differentiate their products.

Firms can differentiate their products through marketing, which refers to all the
activities necessary for a firm to sell a product to a consumer. Marketing includes
activities such as determining which product to produce, designing the product,
advertising and distributing the product, and monitoring how consumer tastes affect the

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 16

market for the product. Firms use two marketing tools to differentiate their products:
brand management and advertising.

A. Brand Management
Brand management refers to the actions of a firm intended to maintain the
differentiation of a product over time. Firms use brand management to postpone the
time when they will no longer be able to earn economic profits.

B. Advertising
A successful advertising campaign will allow a firm to sell more of its product at
every price, and it will be able to increase the price it charges without losing many
customers. But advertising also increases costs. If the increase in revenue that
results from the advertising is greater than the increase in costs, the firm’s profits will
rise.

C. Defending a Brand Name

Once a firm has established a brand name, it has an incentive to defend it. A firm
can apply for a trademark, which grants legal protection against other firms using a
product’s name. A company will spend substantial amounts of money to ensure that
its brand names are entitled to legal protection.

If a firm’s trademarked name becomes widely used for a type of product, the firm may
no longer be entitled to legal protection from unauthorized use of that trademarked
name.

7.5.1 Marketing consists of all the activities that are necessary for a firm to sell a
product to a consumer. Marketing is not limited to only advertising. Product
placement and defending a brand name can also be included under marketing.

7.5.2 Firms are concerned about brand management because (1) maintaining their
product’s unique identity and (2) a good reputation are necessary to prevent
competitors from attracting their customers.

7.5.3 Advertising is a fixed cost, so it will shift up the ATC curve, but not the MC curve.

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 17

What Makes a Firm Successful?

7.6
Learning Objective: Identify the key factors that determine a firm’s success.

A firm’s owners and managers can control some of the factors that allow it to make
economic profits. Examples include the firm’s ability to differentiate its product and
produce a product at a lower average cost than competing firms. Some factors that
affect a firm’s profitability are not directly under the firm’s control; for example, increases
in input prices. Sheer chance also plays a role in the success of a business.

7.6.1 A monopolistically competitive firm’s profitability depends on its ability to

differentiate its products (especially to make them seem more desirable than
competitors’ products) and to produce its product at a lower average cost than
competing firms.

7.6.2 A monopolistically competitive firm can continually earn economic profits greater
than zero only if it always stays one step ahead of the on-rushing competition.

7.6.3 A firm may change market niches because it fears its traditional market is being
reduced by competition and hopes the new niche will be more profitable.
Starbucks is currently expanding from the coffee-only niche to the breakfast/light
food niche to combat increasing competition in coffee sales.

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 CHAPTER 7 | Firms in Perfectly Competitive Markets & Monopolistic Competition 18

Review Questions

Question 1

(a) Identify and briefly explain five (5) characteristics of perfectly competition.

(b) Can a firm in a perfectly competitive market choose the price at which it sells its goods?
How is the price determined?

Question 2

(a) Define the term “barriers to entry” in monopoly.

(b) Barriers to entry serve to perpetuate supernormal profits. Identify and explain four (4)
sources of barriers to entry in monopoly.

Question 3

(a) Should a firm ease production if its average revenue below average cost (AR<AC) in the
short run? Long run? Explain with the aids of relevant diagrams and provide some
numerical examples.

(b) Assume a perfectly competitive firm in the short-run is earning above normal profits.
Explain what will happen to these profits in the long run under this market structure.
Provide diagrams to support your answer.

Question 4

A car wash operator reports the following costs and revenue:

Average cost of production is $12

Output is 6,000 units per month
Total fixed cost is $24,000 per month
Sales revenue is $42,000 per month

As the operator is making losses, analyses if it should shut down its operation.

©2013 Pearson Education, Inc. Publishing as Prentice Hall