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Correct me if I'm wrong, but this is my understanding:

  • In perfect competition, firms set the price at the marginal cost of production. This gives them a relatively low amount of profit.
  • In monopolistic competition, a firm would set the price higher than the marginal cost of production, and thereby gain more profit.
  • In a real economy, firms in some industries (e.g. computer software) are more in a state of monopolistic competition, where they may have more profit. Firms in other industries (e.g. gas stations) are closer to perfect competition, with lower profits.
  • When possible, firms wish to break into industries where firms make more profit. This creates an opportunity cost for staying in the perfectly competitive industry.
  • Does this opportunity cost drive up prices in the lower-profit, more competitive industry, above the marginal cost of production?

So, as a specific example, gas stations pretty much directly compete with nearby gas stations on price. Firms in many other markets have more market power and may make more profit. Does the opportunity cost of not switching to one of those other markets, allow the gas stations to increase the price of gas above the marginal cost (before accounting for that opportunity cost)?

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  • $\begingroup$ Hi! In both the perfect & monopolistic competition models the "supply" of firms is unlimited; a capitalist could potentially have firms both in a perfectly competitive industry and a monopolistically competitive industry. Thus there is no opportunity cost for staying in one. $\endgroup$
    – Giskard
    Aug 8, 2022 at 7:33
  • $\begingroup$ You might mean a more realistic model where a capital supply curve exists, and thus the cost of capital goes up as the number of firms increases. In this case IMO you would need to lay out the precise details of your proposed model, as any potential answer will depend on these details. $\endgroup$
    – Giskard
    Aug 8, 2022 at 7:34
  • $\begingroup$ @Giskard I was thinking a capitalist has a fixed amount of money to invest, which could either go to a perfect competition firm, or a monopolistic competition firm for the same cost. Unless the perfect competition firm can operate in a way to give the same profit as the monopolistic one, then the capitalist would always choose to invest the money on the monopolistic firm, because the return is better. So if the perfect competition firm is to get any investment at all, it has to set prices high enough so it has a similar return on investment to the monopolistic firm $\endgroup$
    – causative
    Aug 8, 2022 at 7:56
  • $\begingroup$ ... even if that is above the marginal cost of production. And it would get away with this because all the other perfect competition firms are under the same pressure to attract investment. They can't set prices lower or their investors/owners would rather invest their money in a different industry. $\endgroup$
    – causative
    Aug 8, 2022 at 7:57
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    $\begingroup$ Again, what you describe is not "perfect competition", the supply of firms/capital is infinite there. Perhaps you mean the demand is perfectly elastic in one market? $\endgroup$
    – Giskard
    Aug 8, 2022 at 8:31

1 Answer 1

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In perfect competition, there are no profits at all. Given the profit function: $\Pi = (P-MC)Q $, if $P=MC$, then $\Pi =0$.

If you believe in the Arrow's replacement effect, the perfectly competitive firm has higher incentives w.r.t. the monopolist to undertake innovation. Indeed, if the monopolist undertakes innovation is going to replace its own already existing profits. In contrast, a competitive firm makes zero profits and has no profits to replace. So, a potential entrant has stronger incentives to undertake an innovation. Of course, in reality, also the monopolist has incentives to undertake an innovation to keep its monopolist power.

If innovation is drastic, the new entrant, i.e. the new monopolist, enjoys a very low MC w.r.t. the perfectly competitive firms and eventually it can fix its price below the MC of the perfectly competitive firms

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  • $\begingroup$ I was taught that the profit of producing Q units under perfect competition is \sum_q=1^Q (P - Cost(q)), where Cost(q) is the cost of producing the q'th unit, and is an increasing function of q, and P = Cost(Q) which is the marginal cost at quantity Q. This profit is greater than 0 because Cost(q) is less than P for all units except when q=Q. $\endgroup$
    – causative
    Aug 8, 2022 at 9:22
  • $\begingroup$ It depends on how the MC behaves. If the MC is increasing in q, then you are right. But, if it is fixed for any level of Q, the argument above holds. $\endgroup$
    – Maximilian
    Aug 8, 2022 at 9:42

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