In the short run, firms operating under monopolistic competition can achieve an equilibrium where they do not have any incentive to change their current output level or price. This equilibrium occurs when the firm's marginal cost (MC) equals its marginal revenue (MR), a condition for profit maximization. The price is determined by the demand curve at this quantity, where the price exceeds marginal revenue (MR) due to the downward-sloping demand curve. Firms will continue operating as long as the price is greater than the average variable cost (AVC).
In this market structure, firms can earn supernormal (above-normal) profits or incur losses in the short run. Supernormal profits occur when the price (determined by the demand curve at the equilibrium output) is above the production's average total cost (ATC). Conversely, the firm incurs a loss if the price is below ATC. These outcomes are possible because product differentiation creates market power for firms, leading to a less elastic demand curve.
However, supernormal profits in the short run attract new firms to the market, increasing competition. Over time, this entry shifts the demand curves each firm faces to the left, making them more elastic and driving down prices and profits. As a result, while firms under monopolistic competition can enjoy supernormal profits or suffer losses in the short run, the market dynamics tend to move toward normal profits in the long run as the market becomes more competitive.
In terms of efficiency, firms tend to operate below the minimum efficient scale, which leads to inefficiencies in production. Additionally, there is allocative inefficiency since the price (P) is greater than the marginal cost (MC), meaning resources are not being allocated in the most efficient manner from society's perspective.
