Monopolistic Competition

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Explain whether or not a firm in monopolistic competition earning abnormal profits is productively and allocatively efficient.

A monopolistic competitive industry is made up of a fairly large number of firms. In relation to the size of the Industry, monopolistic competitive firms are small. They produce slightly differentiated products, for example by brand name, color, design and quality of service. A firm in monopolistic competition has a downward sloping demand curve, since they are (extended) price-makers, which means that they are influential enough to affect the price of their product. The demand curve is relatively elastic because of the many substitutes (which are slightly different). A monopolistic competitive firm is able to gain abnormal profits in the short run. In this case the firm is maximizing profits by producing at the level of output where MC=MR. On the diagram below, q1 represents the productively efficient level. Productive efficiency is achieved when the marginal cost is at the lowest average total Cost. This means a productively efficient firm utilizes all its resourses and produces at the lowest cost possible. A monopolistic competitive firm is allocatively efficient when the marginal cost curve intersect the average revenue curve. This is because the price consumers are willing to pay equals the to the marginal utility they recieve. So a firm is allocatively efficient when there is an optimal distribution of the product. It's also called the socially optimum level of output. In this case, when a firm in monopolistic competition is earning abnormal profits, it is neither productively efficient, nor allocatively efficient. This is because the firm produces where marginal costs is equal to the marginal revenue, as opposed to the points of productive and allocative efficiency which are located differently.
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