Why does inefficiency exists in monopolistic competition

Classic monopoly theory was founded—and is normally still discussed today—in this tradition. According to this theory, market failure results when power is concentrated into too few hands. A monopoly is a single provider of a product or service. A monopsony is a single buyer of a product or service. A cartelized oligopoly consists of a few large providers who agree not to directly compete.

A natural monopoly is an unusual cost structure that leads to efficient control by a single entity. In the real world, all of these variations are broadly covered by the concept of monopoly. The concern is that a monopoly will take advantage of its position to force consumers to pay prices that are higher than equilibrium.

Many economists challenge the theoretical validity of general equilibrium economics because of the highly unrealistic assumptions made in perfect competition models.

Some of these criticisms also extend to its modern adaptation, dynamic stochastic general equilibrium. Milton Friedman , Joseph Schumpeter , Mark Hendrickson, and other economists have suggested that the only monopolies that cause market failure are government-protected.

A political or legal monopoly , on the other hand, can charge monopoly prices because the state has erected barriers against competition. This form of monopoly was the basis of the mercantilist economic system in the 16th and 17th centuries. Modern examples of such monopolies exist to some extent in the utilities and education sectors. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

These choices will be signaled globally to our partners and will not affect browsing data. Monopolistically competitive firms maximize their profit when they produce at a level where its marginal costs equals its marginal revenues. Due to how products are priced in this market, consumer surplus decreases below the pareto optimal levels you would find in a perfectly competitive market, at least in the short run.

As a result, the market will suffer deadweight loss. The suppliers in this market will also have excess production capacity. Monopolistic competitive markets can lead to significant profits in the short-run, but are inefficient. The most common example of this is the production of a good that requires a factory.

If demand spikes, in the short run you will only be able to produce the amount of good that the capacity of the factory allows. This is because it takes a significant amount of time to either build or acquire a new factory. If demand for the good plummets you can cut production in the factory, but will still have to pay the costs of maintaining the factory and the associated rent or debt associated with acquiring the factory.

You could sell the factory, but again that would take a significant amount of time. In the short run, a monopolistically competitive market is inefficient. It does not achieve allocative nor productive efficiency. Also, since a monopolistic competitive firm has powers over the market that are similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus, creating deadweight loss.

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.

The profit the firm makes is the the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good.. Short Run Equilibrium Under Monopolistic Competition : As you can see from the chart, the firm will produce the quantity Qs where the marginal cost MC curve intersects with the marginal revenue MR curve. The price is set based on where the Qs falls on the average revenue AR curve. The profit the firm makes in the short term is represented by the grey rectangle, or the quantity produced multiplied by the difference between the price and the average cost of producing the good.

Since monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. Because of the possibility of large profits in the short-run and relatively low barriers of entry in comparison to perfect markets, markets with monopolistic competition are very attractive to future entrants.

In the long run, firms in monopolistic competitive markets are highly inefficient and can only break even. Given a long enough time period, a firm can take the following actions in response to shifts in demand:. In the long-run, a monopolistically competitive market is inefficient. It achieves neither allocative nor productive efficiency. Also, since a monopolistic competitive firm has power over the market that is similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus.

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run.

This increases the need for firms to differentiate their products, leading to an increase in average total cost. This means two things. First, that the firms in a monopolistic competitive market will produce a surplus in the long run.

Second, the firm will only be able to break even in the long-run; it will not be able to earn an economic profit. Long Run Equilibrium of Monopolistic Competition : In the long run, a firm in a monopolistic competitive market will product the amount of goods where the long run marginal cost LRMC curve intersects marginal revenue MR.

The price will be set where the quantity produced falls on the average revenue AR curve. The result is that in the long-term the firm will break even. The key difference between perfectly competitive markets and monopolistically competitive ones is efficiency. One of the key similarities that perfectly competitive and monopolistically competitive markets share is elasticity of demand in the long-run. In both circumstances, the consumers are sensitive to price; if price goes up, demand for that product decreases.

The two only differ in degree. Demand curves in monopolistic competition are not perfectly elastic: due to the market power that firms have, they are able to raise prices without losing all of their customers.

Demand curve in a perfectly competitive market : This is the demand curve in a perfectly competitive market. Note how any increase in price would wipe out demand. Also, in both sets of circumstances the suppliers cannot make a profit in the long-run. Ultimately, firms in both markets will only be able to break even by selling their goods and services. Both markets are composed of firms seeking to maximize their profits. In both of these markets, profit maximization occurs when a firm produces goods to such a level so that its marginal costs of production equals its marginal revenues.

One key difference between these two set of economic circumstances is efficiency. At times, policy makers will place a binding constraint on items when they believe that the benefit from the transfer of surplus outweighs the adverse impact of deadweight loss. Deadweight loss : This graph shows the deadweight loss that is the result of a binding price ceiling. Policy makers will place a binding price ceiling when they believe that the benefit from the transfer of surplus outweighs the adverse impact of the deadweight loss.

Privacy Policy. Skip to main content. Search for:. Impacts of Monopoly on Efficiency. Reasons for Efficiency Loss A monopoly generates less surplus and is less efficient than a competitive market, and therefore results in deadweight loss.

Learning Objectives Evaluate the economic inefficiency created by monopolies. Key Takeaways Key Points The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers. Key Terms monopoly : A market where one company is the sole supplier. Understanding and Finding the Deadweight Loss In economics, deadweight loss is a loss of economic efficiency that occurs when equilibrium for a good or service is not Pareto optimal.

Learning Objectives Define deadweight loss, Explain how to determine the deadweight loss in a given market. Monopolistic competition is viewed as healthier for the economy and is much more common than monopolies, which are generally frowned upon in free-market nations because they can lead to price-gouging and deteriorating quality due to a lack of alternative choices.

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Personal Finance. Your Practice. Popular Courses. Economy Economics. Part Of. Antitrust Laws and Enforcement. Types of Antitrust Violations. What Is Monopolistic Competition? Key Takeaways Monopolistic competition occurs when an industry has many firms offering products that are similar but not identical.

Unlike a monopoly, these firms have little power to curtail supply or raise prices to increase profits.

Firms in monopolistic competition typically try to differentiate their products in order to achieve above-market returns.