Question

Monopolistic competition is an inefficient market structure because a. firms earn zero profit in the long run. b. marginal cost is less than price in the long run. c. a wider variety of products is available compared to perfect competition. d. all of the above.

Short answer

The correct answer is 'b', as only option b (marginal cost is less than price in the long run) explains why monopolistic competition is an inefficient market structure due to firms setting the price higher than the marginal cost to maximize their profits, which leads to deadweight loss and inefficiencies.

Step-by-step solution

Option a: Firms earn zero profit in the long run.

Monopolistic competition has a large number of firms producing different products. In the long run, with free entry and exit, firms will compete until they earn zero economic profit. However, this does not mean that the market structure is inefficient. So, option a is not the correct answer.

Option b: Marginal cost is less than price in the long run.

In monopolistic competition, firms have some market power due to differentiated products. This causes the demand curve for their products to be downward sloping. As a result, they will set the price higher than the marginal cost to maximize their profits, which leads to deadweight loss and inefficiencies. Option b is, therefore, a valid reason for the inefficiency in monopolistic competition.

Option c: A wider variety of products is available compared to perfect competition.

In monopolistic competition, the availability of a wider variety of products is a result of product differentiation and is not necessarily a factor contributing to market inefficiencies. So, option c is not the correct answer.

Conclusion:

Among the given options, only option b (marginal cost is less than price in the long run) explains why monopolistic competition is an inefficient market structure. Therefore, the correct answer is 'b'.

Key concepts

Market Inefficiencies

When studying monopolistic competition, we often encounter the term market inefficiencies. In essence, this refers to situations where resources are not allocated optimally, leading to a loss of potential economic welfare.

In the context of monopolistic competition, market inefficiencies arise because firms have the power to set prices above marginal cost. This results in a deadweight loss because not all mutually beneficial trades between consumers and producers occur. Compared to a perfectly competitive market where price equals marginal cost, the higher price and reduced output in monopolistic competition reflect inefficient resource allocation. Although consumers enjoy a variety of products, the overall market is less efficient due to this deadweight loss. To make this concept clearer, think about how these inefficiencies affect both consumer choice and costs—while we might enjoy the diversity of products, we often pay a premium due to the lack of perfect competition.

Economic Profit

The term economic profit is different from accounting profit as it considers both explicit costs and implicit costs, such as opportunity costs. In monopolistic competition, the long-term economic profit tends to be zero due to the process of firms entering and exiting the market.

Firms that are able to differentiate their product can initially earn an economic profit, attracting new entrants to the market. Over time, however, the entry of new competitors erodes these profits until firms just break even economically. A zero economic profit is a signal that firms are covering all their costs, including opportunity costs, and there is no incentive for additional firms to enter or for existing firms to exit. This is a key dynamic of monopolistic competition—although firms might make profits in the short-term, the nature of the market structure pushes long-term profits to zero.

Product Differentiation

Product differentiation is a hallmark of monopolistic competition and refers to the process by which firms make their products distinct from those of competitors. By doing so, they can appeal to consumers' preferences and create a form of market power.

Product differentiation can be based on quality, branding, location, and other factors that make a product unique. This is beneficial for consumers as it increases the variety of goods available, satisfying a range of needs and tastes. However, it also means that firms do not compete purely on price, as they do in perfect competition, leading to less price sensitivity among consumers since they may be more concerned with the unique attributes of a product than finding the cheapest option. This is critical to understand, as the breadth of choices and the preferences consumers express play a significant role in shaping the demand curve that monopolistically competitive firms face.