Most restaurants, hair salons and clothing brands are neither price takers nor monopolies. Each has a slightly different product, so it faces a downward-sloping demand curve and picks a price as a monopoly does (The Monopolist's Price and Output), but anyone can open a new one, as in the competitive industries of Allocative and Productive Efficiency.
Key idea
Monopolistic competition: many firms, differentiated products and free entry. In the short run each firm sets $MR = MC$ and can earn a profit. In the long run, entry pulls each firm's demand curve left until it just touches ATC: zero economic profit, with $P = ATC$ but $P > MC$, and output below the minimum of ATC (excess capacity).
Why it works
Profits at the coffee shops in a neighborhood attract new coffee shops. Each newcomer takes some customers from the others, shifting each firm's demand curve left. That continues until no firm can earn more than a normal profit. At that point the demand curve is tangent to ATC: the best the firm can do is break even. Since the demand curve slopes down, the tangency happens on the falling part of ATC, so each firm produces less than the output that would minimize its average cost.
Worked example: Short run
A bakery with a popular new bread faces demand $P = 14 - Q$ (Q in loaves a day), has a marginal cost of \$4 and, at its chosen output, an ATC of \$7. Find its quantity, price and daily profit.
- $MR = 14 - 2Q = 4$, so $Q = 5$; price $= 14 - 5 = \$9$.
- Profit $= (\$9 - \$7) \times 5 = \$10$.
Answer: 5 loaves at \$9 each; profit \$10 a day.
Worked example: Long run
New bakeries open nearby with similar breads. What happens to this bakery's demand curve, price and profit over time?
- Its customers have more substitutes: its demand curve shifts left (and becomes more elastic).
- Entry continues until demand just touches ATC: economic profit falls to zero.
- The price still exceeds MC, so it is not allocatively efficient, and it produces short of minimum ATC.
Answer: Demand shifts left until profit is zero.
Common mistake
Expecting long-run profits, as for a monopoly. A monopoly is protected by barriers to entry; a monopolistic competitor isn't, so new rivals keep arriving until profits are gone. Check: ask "can new firms enter?" If yes, long-run economic profit is zero.
Is the excess capacity waste? Partly, but it buys variety: more styles, locations and flavors than a perfectly competitive market of identical products would offer. How to weigh the two is a matter of judgment.