Economists have long debated whether there is a significant loss of well-being to society in markets that are monopolistically competitive rather than perfectly competitive. Which of the following offers the best reason why some economists believe that monopolistically competitive markets are less efficient than perfectly competitive markets?
A) In contrast to perfectly competitive markets, neither allocative efficiency nor productive efficiency are achieved in monopolistically competitive markets.
B) In contrast to perfectly competitive markets, firms in monopolistically competitive markets earn economic profits in long-run equilibrium.
C) In contrast to perfectly competitive markets, firms in monopolistically competitive markets do not produce where price equals average total cost in long-run equilibrium.
D) In contrast to perfectly competitive markets, firms in monopolistically competitive markets can charge a price greater than average total cost in the short run.
The correct answer and explanation is :
The correct answer is:
A) In contrast to perfectly competitive markets, neither allocative efficiency nor productive efficiency are achieved in monopolistically competitive markets.
Explanation:
Monopolistically competitive markets are characterized by many firms selling differentiated products, which gives them some degree of price-setting power. This market structure leads to inefficiencies when compared to perfect competition.
- Allocative Inefficiency:
- In a perfectly competitive market, firms produce where P = MC, meaning that the price consumers pay reflects the true cost of producing the good, leading to optimal resource allocation.
- However, in monopolistic competition, firms have some market power and set prices above marginal cost (P > MC). This results in a deadweight loss, as some consumers who would have been willing to buy at the competitive price are priced out of the market.
- Productive Inefficiency:
- Productive efficiency occurs when firms produce at the lowest possible cost, which happens when output is at the minimum of the average total cost (ATC) curve.
- In monopolistic competition, firms operate with excess capacity because they do not produce at the minimum ATC. Instead, they restrict output to keep prices higher than marginal cost, meaning they do not achieve the lowest cost per unit production.
These inefficiencies mean that monopolistically competitive markets do not maximize social welfare as efficiently as perfectly competitive markets, where firms produce the optimal quantity of goods at the lowest possible price.
Image:
Here is the generated image comparing the inefficiencies of monopolistic competition with perfect competition. The diagram illustrates how monopolistic competition leads to allocative and productive inefficiencies, highlighting deadweight loss and excess capacity.