Business Economics · Profit maximisation under imperfect competition

Monopolistic Competition: Short-Run and Long-Run Equilibrium

Updated 11 October 2026 · Fact-checked

Monopolistic competition is a market with many firms, free entry and exit, and differentiated products. Each firm faces a downward-sloping demand curve and sets output where MR = MC. In the short run it can earn supernormal profit. Entry removes this, so long-run price equals average cost, with excess capacity.

Understand Monopolistic Competition

Monopolistic competition sits between perfect competition and monopoly. There are many sellers and entry and exit are free, as in perfect competition. But each firm sells a differentiated product, through brand, quality, location or service. Think of restaurants, salons or local shops.

Because products are differentiated, each firm has some control over price. Its demand curve slopes downward. This is the monopoly feature. But the demand is fairly elastic, because close substitutes exist. If the firm raises price, many customers move to rivals.

In the short run, the firm acts like a monopolist. It finds the output where MR = MC, then reads the price from its demand curve at that output. If price is above average total cost (ATC), it earns supernormal profit. If price is below ATC, it makes a loss. It can also be at normal profit.

In the long run, entry and exit change things. Supernormal profit attracts new firms. Their products take away some of each existing firm's customers, so each firm's demand curve shifts left and becomes more elastic. This continues until the demand curve is just tangent to the ATC curve. Losses work the other way: firms exit, demand for the remaining firms shifts right, until the same tangency is reached.

At the long-run equilibrium, MR = MC and price = ATC, so supernormal profit is zero (only normal profit). Since the tangency point lies on the falling part of ATC, output is below the output at minimum ATC. The gap is excess capacity. Price is also above MC, so the outcome is not allocatively efficient. Some argue the variety offered is a benefit that offsets this.

Key rules to remember

Profit-maximising rule: MR = MC (with MC cutting MR from below); Set output here, then read price from the demand (AR) curve.
Profit per unit and total profit: Total profit = (P − ATC) × Q; Positive means supernormal profit, zero means normal profit, negative means a loss.
Long-run equilibrium condition: MR = MC and P = AR = ATC; Demand is tangent to ATC, so supernormal profit is zero.
Excess capacity: Excess capacity = Q at minimum ATC − Q at long-run equilibrium; Positive because the tangency lies on the falling part of ATC.
Linear demand and MR: If P = a − bQ, then TR = aQ − bQ² and MR = a − 2bQ; MR has the same intercept and twice the slope of demand.

How to solve Monopolistic Competition questions

Use this order for any question on monopolistic competition, whether it is a diagram, a calculation or a discussion.

1Confirm the market features: many firms, free entry and exit, differentiated products. Say so briefly.
2Draw or write the demand (AR) curve as downward sloping, with the MR curve below it.
3Find the output where MR = MC.
4Read the price from the demand curve at that output, and the ATC at the same output.
5Compare P with ATC. If P > ATC there is supernormal profit, if P < ATC a loss, and if P = ATC normal profit. Compute (P − ATC) × Q if numbers are given.
6For the long run, state the entry or exit effect: demand shifts and becomes more elastic until P = ATC at the MR = MC output.
7State the results: zero supernormal profit, price above MC, output below minimum-ATC output (excess capacity).
8If asked to compare, contrast with perfect competition (P = MC, minimum ATC) and monopoly (barriers, possible long-run supernormal profit).

Quickest way: MR = MC, then compare P with ATC

When to use it: Use this for numerical questions with a given demand function and cost function, or when you must sketch a diagram fast.

Write MR from demand: for P = a − bQ, MR = a − 2bQ.
Set MR = MC and solve for Q.
Substitute Q into demand to get P.
Substitute Q into ATC to get ATC, then compute (P − ATC) × Q.
For long run, just state P = ATC and zero supernormal profit, and note that Q is below the minimum-ATC output.

Common mistakes in Monopolistic Competition

Reading the price off the MC curve instead of the demand curve.
Students find the MR = MC point and stop there.
Fix: Go up from the MR = MC output to the demand (AR) curve. That point gives the price.
Saying long-run profit is zero in the sense of no profit at all.
The words zero profit are used loosely.
Fix: Say zero supernormal (abnormal) profit. The firm still earns normal profit, which is included in costs.
Drawing the long-run equilibrium at the minimum point of ATC.
Students copy the perfect competition diagram.
Fix: Draw demand tangent to ATC on its falling part. The output is to the left of minimum ATC, which shows excess capacity.
Drawing MR with the same slope as demand.
Students forget MR falls faster for a downward-sloping demand curve.
Fix: For linear demand, MR has twice the slope and the same price intercept.
Treating monopolistic competition and monopoly as the same.
Both have downward-sloping demand.
Fix: Point out free entry and exit and many close substitutes in monopolistic competition. These remove long-run supernormal profit, which a monopoly with barriers can keep.
Claiming the long-run outcome is always inefficient overall.
Students stop at price above MC.
Fix: State that it is not allocatively or productively efficient, but note that consumers get variety, which may be a benefit.

Worked examples

Example 1

A firm in monopolistic competition faces demand P = 100 − 2Q (P in ₹, Q in units). Its total cost is TC = 200 + 20Q. Find the short-run profit-maximising output, price and profit.

Show the solution

TR = PQ = 100Q − 2Q², so MR = 100 − 4Q.
MC = d(TC)/dQ = 20.
Set MR = MC: 100 − 4Q = 20, so Q = 20.
Price from demand: P = 100 − 2 × 20 = ₹60.
ATC = TC ÷ Q = (200 + 20 × 20) ÷ 20 = 600 ÷ 20 = ₹30.
Profit = (P − ATC) × Q = (60 − 30) × 20 = ₹600.

Answer: Q = 20 units, P = ₹60, supernormal profit = ₹600. New firms would enter and shift this firm's demand left in the long run.

Example 2

Explain, with a diagram described in words, why a monopolistically competitive firm earns zero supernormal profit in the long run and operates with excess capacity.

Show the solution

Start with the short-run position: the firm earns supernormal profit where MR = MC, with price above ATC.
Free entry means new firms with close substitutes enter. Each existing firm loses customers, so its demand curve shifts left and becomes more elastic.
Entry continues until demand is tangent to ATC. At that output MR = MC, and price equals ATC, so supernormal profit is zero.
Because demand slopes downward, the tangency point must lie on the falling part of ATC, to the left of the minimum-ATC output.
The difference between the minimum-ATC output and the equilibrium output is excess capacity. The firm could lower unit cost by producing more, but that would need a lower price and would not maximise profit.
Price exceeds MC, so there is no allocative efficiency. Consumers do gain from product variety.

Answer: Entry removes supernormal profit until P = ATC. Tangency on the falling ATC curve gives output below the cost-minimising level, which is excess capacity.

Exam tips

Draw the long-run diagram carefully: demand tangent to ATC, MR cutting MC directly below the tangency point. Label P, Q, MC, ATC, AR and MR.
In MCQs, check for the words differentiated, free entry and excess capacity. They point to monopolistic competition.
For compare questions, use a short list: number of firms, product type, entry barriers, long-run profit, efficiency.
In numerical questions, show MR, the MR = MC solution, the price and the profit. Method marks are easy to earn.
Only say that firms have excess capacity or are inefficient when you can give the reason: tangency on the falling part of ATC, and P > MC.

Practice questions from Profit maximisation under imperfect competition

Monopolistic Competition in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Monopolistic Competition: frequently asked questions

What is the difference between monopoly and monopolistic competition?

A monopoly has one seller and strong barriers to entry, so it can keep supernormal profit in the long run. Monopolistic competition has many sellers, free entry and differentiated products, so long-run supernormal profit is competed away. Both face downward-sloping demand, but demand is more elastic under monopolistic competition.

Why is there excess capacity in monopolistic competition?

In long-run equilibrium, demand is tangent to ATC on its falling section. So the firm produces less than the output at minimum ATC. That gap is excess capacity.

Can a monopolistically competitive firm make a loss in the short run?

Yes. If price at the MR = MC output is below ATC, the firm makes a loss. It continues in the short run if price covers average variable cost. In the long run, losses lead to exit until normal profit is restored.

Is monopolistic competition efficient?

Not in the strict sense. Price exceeds MC, so it is not allocatively efficient, and output is below the minimum-ATC level, so it is not productively efficient. Product variety is a possible benefit.