The above analysis of demand, in addition with the short-run supply curve, will show the short-run equilibrium of a firm under perfect competition. To construct the firm’s supply curve, we need to see the quantity of the goods, which the firm in the industry supply at a given price. Each firm uses the marginal condition (MC = MR) to find the best positive level of output and then uses the average condition to check whether the price for which this output is sold, covers the average cost.
y
Short-run supply curve.
Po Demand curve.
P1
Average variable cost curve.
P2
0 X2 X1 x
The above diagram shows the demand and supply curve. The equilibrium price P1 is the price at which the supply and demand curve, intersect. At that price we see that the quantity demanded is equal to the quantity supplied and both are X1. it is clear that any buyer can buy at that price and any producer can sell at that price also. In addition that point is not only above the average variable cost, but it also makes profit. Looking closer to the short-run equilibrium we can summarise that the firm bases its decisions on its demand curve. Because in perfect competition each firm is a price taker, the firms demand curve is also marginal revenue curve.
Moving from short-run to long-run equilibrium, we should start by finding the long-run supply curve of a firm under perfect competition and then As in the short-run, in order to find the long-run equilibrium, we take again the intersection of the demand curve with the supply curve.
Price Long-run marginal cost curve.
Pa
Pb
Pc
Qc Qb Qa
Output
Supposing the firm is facing a price of Pa, and then the firm will have an output level of Qa. Then we must check if the firm can produce this output or close down. The firm in the long-run, exits from the industry if the price cannot cover the long-run average cost. At price Pc the firm is loosing and should leave the industry in the long-run. So we conclude that the long-run supply curve of the firm is the portion of the long-run marginal cost curve to the right of point Pb, Qb. At that point the firm just make profit.
Starting the discussion about the S-R and L-R equilibrium positions of a firm under monopolistic competition, it would be better to give some definitions about monopolistic competition. Looking at the theory of monopolistic competition, which was independently invented around 1930’s, we see that it is contained by a large number of firms, quite small in size. Each firm under monopolistic competition can give small attention to the possibility that its own decisions disturb any adjustment in other firm’s behaviour. It is also assumed free entry and exit from the industry in the long run. Also, in monopolistic competition each firm faces a downward sloping demand curve. More generally, monopolistic competition analyse an industry in which every single firm can and is able to influence the market share to some extent by charging its price relative to its competition.
Looking closer to the short run equilibrium of a monopolistic competitive firm, we have to assume that firms are profit maxi –misers. As we said the monopolistic competition is close to perfect competition, described above. One similarity is traced here. The short-run equilibrium is the same as perfect competition. In order to find the maximum profit output, we have to look at MR=MC. We see that that the equilibrium point is where output M is equal to the market price D. in addition, the rectangle ADCB, is the supernormal profit and is equal to price, minus TC multiplied by output
Leaving the short-run equilibrium and moving to long run, we have that it is the same as monopoly. The tricky point is that because firms have barriers to enter the market, the equilibrium is the same in short-run and long-run.
At this point we have to say that if the existing firms are making supernormal profit, new firms will try to enter the industry, attracted from these profits. This event will increase the total supply of the industry, but also the demand for the product of each existing firm. This occurs because the current demand must be shared among more and more firms. The effect of this is to shift demand curve of each existing firm to the left, because the market share is reduced. This will continue until the point where the average firm of the industry is making not supernormal profit anymore, but normal. When a firm is making normal profit, the its Demand curve is tangent to the Average Cost curve. The diagram below shows the long-run equilibrium of a firm under monopolistic competition, which is located at E, where the demand curve is tangent to AC
After analysing the SR and LR equilibrium points of both perfect competition and monopolistic competition, the next subject of discussion is to see which one is less efficient. From all the predefined, we could easily come to the conclusion that monopolistic competition is more efficient that perfect competition, because under monopolistic competition the entry is free and because profits are eliminated in the long run. This is an easy mistake, however this opinion is quite unstable, considering the following.
When a firm achieves any level of market power by differentiating its product, as in monopolistic competition, we know that its profit-maximizing strategy is to hold down producing and charge a price above marginal cost. In addition, that price is the value that market places on a good, and marginal cost is the value that market places on the assets needed to produce that good. By deciding to hold down the production and the price above marginal cost, monopolistically competitive firms prevent the efficient use of recourses. The conclusion is that more products could be produced at resource cost below the value that consumers place on the products.
Most industries that comfortably fit the model of monopolistic competition are very competitive. Price competition coexists with product competition, and firms do not earn very large profits. Neither do they violate any of the competition laws.
Monopolistically competitive firms have not been subject of great concern among economic policy makers. Their behavior appears to be sufficiently controlled by competitive forces, and no serious endeavor has been made to regulate or control them.
But monopolistic competition leads to less efficient use of resources than perfect competition. If all firms in a monopolistically competitive industry produce identical goods, then each firm will face a perfectly elastic demand curve. In the long run such firms will produce at the point of minimum average total cost and charge a price equal to marginal cost. But achieving that outcome will itself have a cost. The cost is the absence of product differentiation. Consumers measure variety, but variety is only achievable if firms make differential goods. The loss in locative efficiency that occurs in monopolistic competition has to be weighed the gain of greater good variety.
