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Long run economic profit for monopolistic competition

AP Micro: PRD‑3 (EU), PRD‑3.B (LO), PRD‑3.B.10 (EK)

Video transcript

- [Instructor] We have already thought about the demand curves for perfect competition and monopolies and the types of economic profit that might result in. And this video, we're going to focus on something in between, which we've talked about in previous videos, which is monopolistic competition. So, as you can see in all three scenarios, we have a similar cost structure. We have our marginal cost curve and our average total cost curve that's at a minimum point right where it intersects the marginal cost curve. But it's very different whether we're talking about a monopoly or perfect competition when it comes to the demand curve. For perfect competition, it is one of many firms with an undifferentiated product and no barriers to entry. So, these firms just have to be price-takers. Whatever the price is in the market, each of those firms just have to take that price. And that price is going to be their demand curve and their marginal revenue curve. And we've talked about that, in the long run, under perfect competition, none of these firms are going to be able to make an economic profit; that, if they are, they're going to have more entrants, which is going to push this price down. And if they're making negative economic profit, then you're going to have people who are going to exit, which is going to push line up. And so, it's going to, in the long run, be at a point where none of the firms are making economic profit. And so, another way to think about it, where our marginal revenue curve intersects with our marginal cost curve, which for any of these situations, is the rational amount to produce, the rational quantity to produce for a profit-maximizing firm, that's going to be exactly at a level where the price is equal to average total cost, so you have zero economic profit, zero economic profit. Now, there's some interesting things about this. We talked about how it's allocatively efficient because we're producing at a quantity where marginal cost is equal to demand. It's also productively efficient because we're producing at the minimum point of the average total cost curve. So, it's very efficient from a productive point of view. Now, a monopoly is the opposite extreme. They are the only player in the market with insurmountable barriers to entry. And so, their demand curve, they're the only player, so you could view this as the market demand curve, but it's their demand curve 'cause they're the only product there. So, at high prices, you have a low quantity demanded; and at low prices, you have a high quantity demanded. At in multiple videos, we've talked about that, in many situations, a monopoly firm cannot do price discrimination. It has to charge the same price to every consumer. Well, in that situation, your marginal revenue is going to go down twice as fast because, as you go further and further down the demand curve, you're lowering the price for everyone. And we've studied this, this is all review; but it never hurts to get more review. The rational quantity to produce, and once again, this is true for any firm, is where marginal revenue intersects marginal cost. So, we would produce at that quantity. And the price at that quantity, we'd go to the demand curve, it would be right over there. And you could see that this monopoly firm is able to get quite a nice economic profit because the average total cost at that quantity is right over there. And so, on a per-unit basis, they're able to make that much times the number of units. And so, you have a nice economic profit. Now, the negative, from a economic or market point of view, if you were to be allocatively efficient, you'd be producing at a quantity where marginal cost intersects demand. But that is not happening over here. And so, you have all of this deadweight loss right over there. Now, to help understand monopolistic competition, let's say you start as a monopoly; but now, all of a sudden, the market dynamics have changed, where what were insurmountable barriers to entry now become low barriers to entry. What is likely to happen? Well, you have this nice economic profit going on here, so more firms are likely to enter the market. And if more firms enter the market, what is going to happen to your demand curve? Well, the demand for your specific product is going to go down because there's other people who are offering similar alternatives. In monopolistic competition, you aren't completely undifferentiated. You might have a brand, you might have certain features that are better or worse, but there are other substitutes which people could go for, which are giving you that competition. So, as more and more people enter, as you have this economic profit, your particular demand curve is going to shift down and to the left. And so, your demand curve will keep shifting until you're no longer able to get any economic profit. And so, your demand curve might go something like this. Once the firms aren't able to get economic profit, well then it doesn't really make sense for more people to try to enter it. So, if you started a monopoly, your demand would shift to the left, like that, to the point where you get like that. And your marginal revenue curve would look something like this, it would have twice the slope down, so this would be your marginal revenue curve. And notice what has now happened. It is now rational for you to be producing at a quantity where the price that you are getting is equal to your average total cost. So, once again, as more and more people entered, because you were getting economic profit, and the players in this industry were getting economic profit, the demand curve has shifted left, so now there is zero economic profit in the long run. Now, once again, this is a situation here you have deadweight loss. This is not allocatively efficient. You're not producing at a level where marginal cost is equal to demand. It's also not productively efficient. To be productively efficient, you'd be producing at a quantity where you're at the minimum point of your average total cost curve. And so, this difference right over here, we could view this as the quantity for, I'll call it efficient scale, this right over here, this distance, you could view this as excess capacity, excess capacity. Now, one thing that might be a little bit counterintuitive is, in previous videos, we talk about how, hey, as people enter and exit a market, it would shift the supply curve. But here, we're shifting the demand curve. Well, when people enter and exit the market, it shifts the supply curve for the entire market. It would not shift the demand curve for the entire market. But what we have drawn over here is not the demand curve for the entire market. What we have drawn here is the demand curve for this particular firm's product. So, as there's more and more entrants in the entire market, the demand for this particular firm's products are going down.
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