On Equilibrium in Monopolistic Competition

The price, output, and quality of a monopolistic competitor are determined by maximizing the difference between its revenue and its cost, where cost is measured exclusive of the rent on its product-specialized inputs. It can be argued that such a firm must have unique inputs that are specialized to its unique product—since product differentiation is otherwise compatible with perfect competition—and the uniqueness of these inputs allows them to earn positive rent, even in long-run equilibrium. The inclusion of rent in cost gives rise to the traditional Chamberlinian solution, in which (rent-inclusive) average cost is tangent to demand and therefore downward-sloping. But if rent is excluded, average cost may be constant or even upward-sloping in equilibrium, and in this sense, monopolistic competition need not give rise to excess capacity or to production facilities that are too small. The basic conclusion is that monopolistic competition improves welfare—that is to say, it creates consumer and producer surplus—by creating variety without necessarily reducing output.