Understanding Pricing and Output Under Monopolistic Competition
In monopolistic competition, firms make price/output decisions as if they were a
monopoly. In other words, they will produce where marginal revenue equals marginal
cost.
Free entry into the market may ultimately shrink the economic profits of monopolistically
competitive firms.
To understand how a monopolistically
competitive firm determines its output and
prices, assume that there is a single fast food
restaurant in a market, as on the left.
This monopolistically competitive firm will
price its product like a monopolist: at the point
at which marginal cost equals marginal
revenue. The output/price combination on the
left is associated with point P. It is behaving
as a monopolist. Its price is greater than
average cost so it realizes an economic profit.
However, as in a competitive market, there is
free entry into the market so other firms will
enter the market enticed by the economic
profits. The firm’s average costs may increase,
or the price may fall and ultimately economic
profits may disappear.
For a monopolistic competitor, the economic
profits may shrink but not completely
disappear.
