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If profits are driven to zero in the long run, it is possible to think that this market is efficient. Remember that two central conditions must hold for a market to be called efficient. The market must be producing at the lowest possible cost and must be producing such that price is equal to marginal cost. Monopolistically competitive markets do neither of these things. But look again at the long-run equilibrium for a monopolistically competitive firm:
Note that the point of tangency between the demand curve and the average total cost curve (ATC) is not at the bottom of ATC. Thus, the monopolistic competitor produces, in the long run, at a price higher than the lowest average total cost. Also note that price is higher than marginal cost, so there is the possibility of Pareto improvement if the firm would make more units. The firm’s effort to differentiate itself is the cause of the downward-sloped demand, and thus, the inefficiency. If the firm were to let demand keep shifting back and get flatter, then the market would become perfectly competitive and efficient. Therefore, the merits of product differentiation are that differentiation comes with inefficiency. Are the benefits of product differentiation greater than the loss in consumer surplus due to inefficiency? Monopolistically competitive firms have not been a subject of great concern among economic policy makers. Their behavior appears to be sufficiently controlled by competitive forces, and no serious attempt has been made to regulate or control them.
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