Monopolistic Competition Page 118

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

Productive efficiency is the point where a firm produces at the lowers possible cost per unit (MC = AC). Allocative efficiency is the socially optimum level of output (MC = AR), where the cost to the firm equals the price which is the benefit to society. Just like a monopoly, a firm in a monopolistically competitive market will produce at the level of output where profit is maximized (MC=MR). Marginal revenue is below demand, meaning that at all levels of output (except the first unit), there is an under-location of resources. The lack of competition causes the firms to produce less than is socially optimal. Society would want more to be produced, but the firms restrict output to maximize profit. For a firm to be productively efficient, it would have to produce at the lowest average total cost. However, firms in monopolistic competition have some price making power, allowing them to produce at the profit maximization point.

For a firm in a monopolistic competitive market to earn abnormal profits its average costs must be lower than its average revenue. The firm will produce at output q to maximize profits, but will not produce at q₁ (productive efficiency) or at q₂ (allocative efficiency).