Figure 3 compares the long-run equilibrium under monopolistic competition to the long-run equilibrium under perfect competition. (Chapter 14 discussed the equilibrium with perfect competition.) There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the markup.

Figure 3 Monopolistic versus Perfect Competition

Excess Capacity As we have just seen, entry and exit drive each firm in a monopolistically competitive market to a point of tangency between its demand and average-total-cost curves. Panel (a) of Figure: shows that the quantity of output at this point is smaller than the quantity that minimizes.

Markup over Marginal Cost A second difference between perfect competition and monopolistic competition is the relationship between price and marginal cost. For a competitive firm, such as that shown in panel (b) of Figure 3, price equals marginal cost. For a monopolistically competitive firm, such as that shown in panel (a), price exceeds marginal cost because the firm always has some market power.

How is this markup over marginal cost consistent with free entry and zero profit? The zero-profit condition ensures only that price equals average total cost. It does not ensure that price equals marginal cost. Indeed, in the long-run equilibrium, monopolistically competitive firms operate on the declining portion of their average-total-cost curves, so marginal cost is below average total cost. Thus, for price to equal average total cost, price must be above marginal cost.

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