Home > Economics FAQs Blogs > To what extent can small firms in a monopolistically competitive market achieve economic efficiency?
To what extent can small firms in a monopolistically competitive market achieve economic efficiency?
Relevant Topics
This question pertains to topics in Microeconomics, such as Market Structures, Efficiency, and Competition.
Definitions:
Monopolistic Competition: A market structure characterised by a large number of small firms selling differentiated products, with low barriers to entry and some degree of price-setting power. Examples include restaurants, fashion retailers, and coffee shops.
Economic Efficiency: This consists of two key forms:
Allocative Efficiency (P = MC):Resources are allocated to maximise consumer welfare, meaning firms produce at the socially optimal level.
Productive Efficiency (P = Minimum AC): Firms operate at the lowest average cost, minimising waste and inefficiencies.
Detailed Explanation:
Firms in monopolistic competition exhibit characteristics that challenge their ability to achieve economic efficiency.
Short-Run Efficiency:
Inefficient Outcomes Due to Pricing Power: Unlike perfect competition, firms in monopolistic competition face downward-sloping demand curves, meaning they set prices above marginal cost (P > MC), leading to allocative inefficiency.
Excess Capacity and Higher Costs: Due to product differentiation, firms do not produce at minimum average cost, resulting in productive inefficiency.
Short-Run Supernormal Profits: If firms create strong brand loyalty or differentiation, they may temporarily earn supernormal profits, but these will erode as new entrants join the market.
Long-Run Efficiency:
Entry of New Firms Eliminates Supernormal Profits: Due to low barriers to entry, new firms enter, increasing competition and shifting demand curves leftwards, driving profits to normal levels. However, firms still do not produce at minimum average cost.
Productive Inefficiency Persists: Firms operate with excess capacity, meaning they produce at higher average costs than necessary.
Potential Gains in Dynamic Efficiency: Some firms reinvest in innovation and brand development, improving quality and consumer choice, which may justify some inefficiencies.
Short-Run Efficiency:
Inefficient Outcomes Due to Pricing Power: Unlike perfect competition, firms in monopolistic competition face downward-sloping demand curves, meaning they set prices above marginal cost (P > MC), leading to allocative inefficiency.
Excess Capacity and Higher Costs: Due to product differentiation, firms do not produce at minimum average cost, resulting in productive inefficiency.
Short-Run Supernormal Profits: If firms create strong brand loyalty or differentiation, they may temporarily earn supernormal profits, but these will erode as new entrants join the market.
Long-Run Efficiency:
Entry of New Firms Eliminates Supernormal Profits: Due to low barriers to entry, new firms enter, increasing competition and shifting demand curves leftwards, driving profits to normal levels. However, firms still do not produce at minimum average cost.
Productive Inefficiency Persists: Firms operate with excess capacity, meaning they produce at higher average costs than necessary.
Potential Gains in Dynamic Efficiency: Some firms reinvest in innovation and brand development, improving quality and consumer choice, which may justify some inefficiencies.
Recent:
UK Coffee Chains (2023): Brands like Pret A Manger and Costa invest in product differentiation but operate with higher prices than marginal cost, reducing efficiency.
Fast-Fashion Industry (2022): Firms like ASOS and Boohoo remain productively inefficient due to rapid product turnover and excess capacity, but benefit consumers through variety and innovation.
Summary:
Small firms in monopolistically competitive markets struggle to achieve allocative and productive efficiency due to pricing power and excess capacity. However, they may contribute to dynamic efficiency by investing in product innovation and brand differentiation. While inefficiencies persist, consumers benefit from greater choice and product variety, making monopolistic competition an economically significant market structure despite its shortcomings
Whenever you're ready there is one way I can help you.
If you or your child are looking to Boost your A level Economics Grades in under 30 days, I'd recommend starting with an all-in-one support network where you get 24/7 access to a SuperTutor:
→ Join EdGenie 🧞♂️: Transform your A-Level Economics essays and exam marks (genuinely) with our comprehensive on-demand learning platform. This carefully curated course blends engaging content with effective exam techniques, the same ones that have empowered over 1,000 of my students to achieve an A or A* over the last 13 years.
Thanks for hopping on board EdGenie's Frequently Asked Questions!
I'm Emre, and I've got a big goal - to make A* education accessible to all A-level students.
And it Starts With You!
Emre Aksahin
Chief Learning Officer at Edgenie
Latest from our blog

Copyright © 2023
School
Join EdGenie 🧞♂️
Unlock Full Access to Examinable
Questions and Answers, Plus:
Questions and Answers, Plus:
- 600+ A* Tutorial Vault ⭐️
- 1-1 Live 24/7 SuporTutor Support 💬
- Live MasterClasses and EssayLabs 🎓
- Downloadable summary sheets 📄
Already a member? Log in
Subscribe to Wednesday Wisdoms
Get weekly updates on
A-Level Economics and Business insights right in your mailbox.
A-Level Economics and Business insights right in your mailbox.
Thank you!
Subscribe to the Edgenie newsletter!
Get weekly updates on the top news of the week, infographics, economic data, and more right in your mailbox.
Thank you!
Join EdGenie 🧞♂️
Unlock Full Access to Examinable
Questions and Answers, Plus:
Questions and Answers, Plus:
- 600+ A* Tutorial Vault ⭐️
- 1-1 Live 24/7 SuporTutor Support 💬
- Live MasterClasses and EssayLabs 🎓
- Downloadable summary sheets 📄
Already a member? Log in
30% discount offer!
30% discount offer!
Click the button to make this offer yours! Limited-time only!