How entry turns short-run profit into the tangency equilibrium, and why that leaves excess capacity.
Walk down almost any high street and count the barbers, cafés and takeaways. There are lots of them, each a little different: a different name, a different location, a slightly different menu or style. Opening one does not cost much, so new ones keep appearing, and others quietly close.
Is that perfect competition, monopoly or something in between? And if one café starts making big profits, what happens next?
A new style of coffee shop makes big profits. Anyone can open one.
Two years later, what has most likely happened to the original shop’s profits?
With low barriers to entry, profit attracts copycats. Each new shop takes some of the original’s customers, so its demand falls until it makes only normal profit. It survives, but the abnormal profit is gone.
Monopolistic competition: many small firms, each selling something slightly different, with low barriers to entry. Only Heinz can make Heinz beans, so a firm with a brand has a small monopoly of its own and its demand slopes down. But there are many close substitutes, so a price rise loses a lot of customers: demand is elastic, flatter than a monopoly’s. With so little power over price, firms compete mainly on branding, quality and service: non-price competition. Draw AR first, then MR, twice as steep.
Now the costs: MC first, then ATC, with MC cutting ATC at its lowest point. In the short run this is the monopoly diagram with a flatter AR.
Check: In the short run, where does this firm produce, and how is its price set?
Like any profit maximiser it produces where MC = MR. The price is the most buyers will pay for that output, so it is read up to the demand (AR) curve.
In the short run it behaves like a small monopoly. Produce where MC = MR1, at Q1. Go up to demand for the price, P1, and read ATC at Q1 for cost per unit.
Price is above ATC, so the firm makes abnormal profit in the short run. Now build the chain that explains what happens next, one link at a time.
Check: The abnormal profit rectangle runs from P1 down to which line?
Profit per unit is price minus average total cost at the output the firm actually produces. The bottom of the box is ATC at Q1, never MC.
Barriers to entry are low, so the profit attracts new firms. Demand is now shared among more firms, so each firm’s demand shifts left. It also becomes more elastic, because there are more close substitutes.
Check: New firms enter. What shifts on this firm’s diagram?
Customers are now shared among more brands, so each firm’s own demand falls. Market supply shifting right is the perfect competition story, and a common slip in essays.
Entry carries on until there is no abnormal profit left to attract anyone else. That happens when AR2 is a tangent to ATC: it touches ATC at one point without crossing it.
The firm still produces where MC = MR, now MR2, at Q2. Directly above it is the tangency point. Price equals ATC, so the firm makes only normal profit. This is long-run equilibrium, and the chain is complete.
Check: In long-run equilibrium, how does AR relate to ATC?
AR is tangential to ATC: it touches at one output and is below ATC everywhere else, so no output earns abnormal profit.
Drawing it in the exam. Show only the long-run position, not both demand curves: it is clearer, and it is what the examiner is looking for. The order matters. Step 1: AR2, then MR2, twice as steep.
Step 2: MC, falling then rising.
Step 3: the output. Mark where MC = MR2 and drop a dotted line to the axis: Q2.
Check: Step 4 is ATC. Where must ATC meet AR2 in long-run equilibrium?
In the long run the firm makes normal profit, so price equals ATC at Q2. ATC just touches AR2 there and lies above it everywhere else.
Step 4: ATC. Draw it as a tangent to AR2 directly above Q2, curving up on both sides, with MC cutting it at its lowest point. This is the step most students rush.
Teacher tip: ATC goes on after the output because it has two jobs: touch AR2 directly above Q2 and pass through MC at its own lowest point. Fit both, even if the curve looks lopsided.
Step 5: the price. Go straight up from Q2 to the tangency and across to the axis: P2 = ATC, normal profit. Label everything.
Now look at where the tangency sits on the ATC curve.
Check: AR2 slopes down. Where on ATC can it be a tangent?
At a tangent the two curves have the same slope. AR2 slopes down, so ATC must be sloping down at that point too, which is only true left of its lowest point.
So the tangency is left of the lowest point of ATC, and the firm produces less than Q*, the output that minimises ATC. That gap is excess capacity: the firm is productively inefficient. Price is also above MC, so it is allocatively inefficient.
They put the firm at the lowest point of ATC, as if it were perfectly competitive. With a downward-sloping AR, the firm produces where MC = MR2, below the tangency, to the left of the lowest point of ATC.
Explain why a firm in monopolistic competition makes only normal profit in the long run, and why it has excess capacity.
In the short run a firm in monopolistic competition can earn abnormal profit, producing where MC = MR and charging a price above ATC.
Because barriers to entry are low, that profit attracts new firms selling similar products. Demand is shared among more firms, so each firm’s demand curve shifts left and, with more close substitutes, becomes more elastic. Entry continues until AR is a tangent to ATC. The firm still produces where MC = MR, directly below the tangency, so price equals average cost and it makes only normal profit.
Because the AR curve slopes downwards, it can only be a tangent to ATC on the falling part of ATC. So the firm produces less than the output at the lowest point of ATC: it has excess capacity and is productively inefficient. Price is also above MC, so it is allocatively inefficient, although consumers gain from a wide variety of products.
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