Question

A monopolistically competitive firm is inefficient because the firm a. earns positive economic profit in the long run. b. is producing at an output where marginal cost equals price. c. is not maximizing its profit. d. produces an output where average total cost is not minimum.

Short answer

A monopolistically competitive firm is inefficient because it does not produce at an output level where marginal cost equals price, resulting in allocative inefficiency (Option b), and it produces an output where average total cost (ATC) is not at its minimum, leading to productive inefficiency (Option d).

Step-by-step solution

Option a: Positive economic profit in the long run

A monopolistically competitive firm earns a positive economic profit in the short run as it has the power to set its price. However, in the long run, new firms will enter the market, causing the demand for the firm's product to decrease, and its price to fall. Eventually, the firm will earn zero economic profits, just like firms in a perfectly competitive market. Option a is not the correct explanation of the firm's inefficiency.

Option b: Output where marginal cost equals price

A firm operating in a perfectly competitive market will produce at an output where marginal cost equals price, ensuring allocative efficiency. A monopolistically competitive firm does not produce at this output level and therefore operates inefficiently in terms of allocative efficiency. So, option b is an accurate description of the firm's inefficiency.

Option c: Firm not maximizing its profit

A profit-maximizing monopolistically competitive firm will produce at an output level where marginal revenue equals marginal cost. In this sense, the firm is maximizing its profit, although it is not producing at the most efficient level in terms of allocative efficiency. Option c is not the correct explanation of the firm's inefficiency.

Option d: Output where average total cost is not minimum

In the long run, a monopolistically competitive firm produces an output where the average total cost (ATC) is not at its minimum level. This implies that the firm is operating with excess capacity and not producing at the lowest possible cost, resulting in productive inefficiency. Option d accurately describes one aspect of the firm's inefficiency. To summarize, a monopolistically competitive firm is inefficient due to the following reasons: 1. It does not produce at an output level where marginal cost equals price, resulting in allocative inefficiency (Option b). 2. It produces an output where ATC is not at its minimum, leading to productive inefficiency (Option d).

Key concepts

Allocative Efficiency

Allocative efficiency occurs when the products being produced are aligned with consumer preferences and each good is priced at its marginal cost—the cost of producing one additional unit. This ensures that resources are distributed in the most beneficial way to society. In a monopolistically competitive market, firms have some control over their pricing and tend to set prices above the marginal cost. Thus, the product quantity produced and sold is less than what would be considered allocatively efficient. This disparity indicates that the resources could be reallocated to increase overall economic welfare. By not producing where price equals marginal cost, a monopolistically competitive firm contributes to a loss in allocative efficiency.

Through this understanding, students can realize that for a market to achieve allocative efficiency, it’s not just about meeting consumer demands but also ensuring that the price reflects the true cost of making one more product—failing to do this leads to an inefficient outcome.

Productive Efficiency

Productive efficiency is achieved when a firm operates at the lowest possible average total cost (ATC), meaning that it cannot produce its current level of output any more cheaply. This indicates full utilization of the firm's resources, including technology and labor. In the context of monopolistic competition, firms do not achieve productive efficiency. They tend to have excess capacity, producing at a level where the average total cost is not minimized. This results in higher costs per unit than necessary, and prices that do not reflect the lowest possible cost of production.

Highlighting this concept allows students to understand that productive efficiency is quintessential for firms to minimize costs and waste less, which in turn can lead to lower prices for consumers and better use of resources throughout the economy.

Economic Profit

Economic profit occurs when a firm's total revenues exceed all costs, including both explicit (direct) and implicit (opportunity) costs. In the short run, a monopolistically competitive firm can earn economic profits because of product differentiation and brand loyalty. However, these profits attract new entrants into the market, increasing competition and eventually driving down profits to zero in the long run. Therefore, the presence of long-term economic profits is not a typical characteristic of monopolistic competition; instead, such firms tend to only break even when factoring in all costs, including the opportunity cost of capital.

By delving into the idea of economic profit, it becomes clear to students why firms might enter or exit markets and how the nature of competition influences a firm's profitability over time.

Marginal Cost

Marginal cost represents the change in total cost that arises when the quantity produced is incremented by one unit. It is vital for determining the optimum level of production for a firm. In the case of a monopolistically competitive firm, the decision of how much to produce hinges on equating marginal cost to marginal revenue rather than price. This leads to a higher price and lower output than what is ideal from an efficiency standpoint. Understanding marginal cost is crucial for students as it teaches the principle of 'opportunity cost' in production—each additional unit produced has a cost that reflects not just the expenditure on materials or labor, but the forgone opportunity to allocate those resources elsewhere.

Clarifying marginal cost can aid in comprehending why a firm prices its goods at a certain point and how this decision impacts both market efficiency and consumer satisfaction.