The assumptions made in monopolistic competition are as follows:
○ The industry is made up of a fairly large number of forms.
○ The firms are small, relative to the size of industry. Therefore firms can act independently of each other.
○ The firms all produce slightly differentiated products.
○ Firms are completely free to enter of leave the industry since there are no barriers to entry or exit.
A monopolistically competitive firm can early earn profits in the short-run. This is because there are no barriers to entry. Such a firm will produce at the profit maximizing point, MC=MR, while its average cost is less than the price it is selling its product for.
Productively efficient is achieved at the level of output where a firm produces at the lowest possible cost per unit, at the point where AC is at a minimum. This is the point where the MC curve cuts the AC curve (AC=MC). If the firm in the diagram above would be productively efficient, it would be producing at the quantity q1 where MC is equal to AC. But it doesn't: it produces at the profit maximizing point MC=MR.
Allocatively efficient is achieved at the level of output where the MC curve cuts the AR curve: the socially optimum level of output. (AR=MC) If the firm in the diagram above would be allocatively efficient, it would be producing at the quantity q2 where MC is equal to AR. But it doesn't: it produces at the quantity q, the profit maximizing point.
A firm in monopolistic competition is neither productively nor allocatively efficient.
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