Monopolistic competition: price, output and the long run

How does a differentiated firm choose its price and output?

Under monopolistic competition many firms sell similar but differentiated products. Because buyers see each firm’s product as a little different, each firm faces a downward-sloping demand curve. It still maximizes profit by producing where marginal revenue equals marginal cost, and then charges the price that demand allows at that output. Product differentiation is what gives the firm that pricing power: quality, features, brand, location or service that buyers will pay for.

There is no well-defined supply curve. The quantity offered depends on where MR meets MC, and the price depends on demand, so the same cost curve can give different outputs under different demand.

Marginal revenue sits below the demand curve, because selling one more unit means cutting the price on all units. For linear demand there is a clean rule.

$$P = a - bQ \;\Rightarrow\; MR = a - 2bQ$$

MR has the same intercept and twice the slope. Setting it equal to marginal cost gives the optimal output.

$$MR = MC \;\Rightarrow\; Q^* = \frac{a - MC}{2b}, \qquad P^* = a - bQ^*$$

$$\pi = (P - ATC)\,Q$$

The interactive below starts from this brewery. To draw an ATC curve with a minimum (and so show excess capacity), it lets marginal cost rise gently, MC = 6 + 0.2Q, which is USD 10 at 2,000 cases. Output, price and profit at the start match the example.

Exam tip The price is read off the demand curve at the MR = MC output. Never off MR or MC.

What happens in the long run?

Entry is easy, so profit does not last. New firms take customers from the incumbents, and each incumbent’s demand curve shifts left until it just touches the average total cost curve. At that point price equals ATC and economic profit is zero. If firms are making losses, exit works in reverse until the survivors break even.

Firm with a differentiated productdownward-sloping demand, MR below it

• Short run Use it
  • Produce where MR = MC price from the demand curve
  • Profit, loss or breakeven depends on price against ATC
• Long run Memorize
  • Entry (profit) or exit (loss) demand shifts until it just touches ATC
  • Economic profit = 0
  • P > MC, output below minimum ATC excess capacity

The tangency happens on the falling part of the ATC curve, so two things stay different from perfect competition. Price is above marginal cost (the markup survives), and the firm produces less than the output that minimizes average cost. That shortfall is excess capacity .

$$P = ATC, \quad P > MC, \quad Q < Q_{\min ATC}$$

This is long-run equilibrium : no firm wants to enter or leave, and no firm can earn more by changing its output. Compare it with perfect competition.

Long run	Perfect competition	Monopolistic competition
Economic profit	Zero	Zero
Price vs MC	P = MC	P > MC
Output vs minimum ATC	At minimum ATC	Below it (excess capacity)
Spending on advertising and differentiation	None	Yes

How do these firms compete on something other than price?

Firms compete on product features, branding, advertising and location rather than on price alone. A successful differentiation strategy makes the firm’s demand less elastic, which moves it towards monopoly-like pricing. The benefit for consumers is variety and innovation, even though price is above marginal cost.

Competing without a lower priceto make demand less elastic

• Product features and quality
• Branding and advertising
• Location and service

Go deeper Why variety has value

Buyers gain from choice: a city with dozens of distinct restaurants serves more tastes than one with a single standardized menu. The same logic explains trade in similar goods between countries, such as cars exported and imported by the same economies. Excess capacity can be seen as the cost of that variety.

Go deeper Advertising: a cost that can also pay for itself

Advertising raises average total cost, which pushes the ATC curve up. But if it makes demand less elastic, the firm can charge a bigger markup. In the long run entry still removes the extra profit, so the advertising spend ends up as part of the cost of competing, not as a permanent gain for the firm.