Monopolistic competition in the long run

A monopolistically competitive firm sells a product that is a little different from its rivals', so it faces its own downward-sloping demand curve and produces where MR = MC. Entry and exit are free, though.

If firms are making economic profit, new rivals enter, each existing firm loses customers, and its demand curve shifts left. If they are making losses, firms exit and demand shifts right. This stops only when economic profit is zero, which means the price on the demand curve equals average total cost at the chosen output: P = ATC. Graphically, the demand curve is just tangent to the ATC curve there.

Because demand slopes down, that tangency happens on the downward part of ATC, to the left of its minimum. That is the excess capacity result, and it is why the firm does not produce at minimum ATC.

Each choice

• A. Producing at minimum long-run ATC is the perfect competition result. With a downward-sloping demand curve, the tangency with ATC falls to the left of the minimum, leaving excess capacity.
• B. Price equals MR only when demand is horizontal, as in perfect competition. This firm's demand slopes down, so its MR is always below price.
• C (correct). Free entry leaves zero economic profit, so P = ATC, even though the firm is not at minimum ATC.
• D. This mixes up two rules. The firm sets MR equal to MC, not to ATC, and no rule for this market structure equates MR with ATC.
• E. Average revenue is price. MR equals AR only when demand is horizontal, which is not the case for a firm with a differentiated product.