Figure 111

Relation Between Product Differentiation and Elasticity of Demand

Firm B's steeper demand curve relative to firm A's reflects stronger product differentiation and hence less sensitivity to price changes.

Over time, short-run monopoly profits attract competition, and other firms enter the industry. This competitive aspect of monopolistic competition is seen most forcefully in the long run. As competitors emerge to offer close but imperfect substitutes, the market share and profits of the initial innovating firm diminish. Firm demand and marginal revenue curves shift to the left as, for example, from D1 to D2 and from MRj to MR2 in Figure 11.2. Optimal long-run output occurs at Q2, the point where MR2 = MC. Because the optimal price P2 equals ATC2, where cost includes a normal profit just sufficient to maintain capital investment, economic profits are zero.

The price/output combination (P2Q2) describes a monopolistically competitive market equilibrium characterized by a high degree of product differentiation. If new entrants offered perfect rather than close substitutes, each firm's long-run demand curve would become more nearly horizontal, and the perfectly competitive equilibrium, D3 with P3 and Q3, would be approached. Like the (P2Q2) high-differentiation equilibrium, the (P3Q3) no-differentiation equilibrium is something of an extreme case. In most instances, competitor entry reduces but does not eliminate product differentiation. An intermediate price/output solution, one between (P2Q2) and (P3Q3), is often achieved in long-run equilibrium. Indeed, it is the retention of at least some degree of product differentiation that distinguishes the monopolistically competitive equilibrium from that achieved in perfectly competitive markets.

A firm will never operate at the minimum point on its average cost curve in monopolistically competitive equilibrium. Each firm's demand curve is downward sloping and is tangent to the ATC curve at some point above minimum ATC. However, this does not mean that a monopolistically competitive industry is inefficient. The very existence of a downward-sloping demand curve implies that consumers value an individual firm's products more highly than they do products of other producers. The higher prices and costs of monopolistically competitive industries, as opposed to perfectly competitive industries, reflect the economic cost of product variety. If consumers are willing to bear such costs, then such costs must not be excessive. The success of branded products in the face of generic competition, for example, is powerful evidence of consumer preferences for product variety.

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