Monopolistic competition

Characteristics of monopolistic competition:

1. There are a large number of small firms: each one is relatively small and can act independently of the market

2. There are low barriers to entry and exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition

3. The products are slightly differentiated: this structure exists as consumers have different desires e.g. two nail bars can differentiate their product through either an express or pampered service. Some consumers may want a quick service, while others want more attention. A relatively homogenous product has now been differentiated

4. There is a low degree of market power and some price setting ability

Profit Maximising Equilibrium in the Short and Long-run

• In order to maximise profit, firms in monopolistic competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)

• The firm does have some market power and is able to influence the price and quantity

  • The firm is a price maker

    • This is due to the fact that they have a differentiated product that is desirable by certain consumers

• The firm can make supernormal profit in the short-run

• In the long-run, the firm will return to a long-run equilibrium position in which they make normal profit

  • This is due to inability to defend against new competitors who enter the market and copy the products of existing sellers

  • Firms will attempt to find new ways to differentiate their product to prolong the period of supernormal profit, e.g. a barber shop may add in a pool table and beer fridge for their customers to enjoy, thus making them different from the competition (for a period of time)

Monopolistic Competition DiagramsShort-run profit maximisation

• Firms in monopolistic competition are able to make supernormal profit in the short-run

• The AR curve is the demand curve of the firm and it is downward sloping

  •  The firm has some market power due to the level of product differentiation that exists

    • To sell an additional unit of output, the firm will have to decrease its price

    • The marginal revenue (MR) curve will fall twice as quickly as the AR

A diagram illustrating a monopolistically competitive firm making supernormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q1)

Diagram analysis

• The firm produces at the profit maximisation level of output where MC = MR (Q₁)

  • At this level the AR (P₁) > AC (C₁)

  • The firm is making supernormal profit

  • = (P1-C1)XQ1

Short-run losses - Firms in monopolistic competition are able to make losses in the short-run

Diagram analysis

• The firm produces at the profit maximisation level of output where MC = MR (Q_E)

  • At this level of output, the AR (P_E) < AC (C₁)

  • The firm's loss is = (PE-C1)XQE

From Supernormal to Normal Profit

• If firms in monopolistic competition make supernormal profit in the short-run, new entrants are attracted to the industry and the number of sellers increases

  • They are incentivised by the opportunity to make supernormal profit

  • There are low barriers to entry

    • It is easy to join the industry

    • Supernormal profit will be eroded and the firm will return to the long-run equilibrium position of making normal profit

From Losses to Normal Profit

• If firms in monopolistic competition make losses in the short-run, some will shut down

  • The shut down rule will determine which firms shut down

  • There are low barriers to exit, so it is easy to leave the industry

• For the remaining firms, losses will be eliminated and the firm will return to the long-run equilibrium position of making normal profit

A diagram illustrating the long-run equilibrium position for a monopolistically competitive firm which is making normal profit. AR (P1) = AC at the profit maximisation level of output (Q1)

Diagram analysis

• The firm is initially producing at the profit maximisation level of output where MC=MR (Q₁)

• At this level of output P₁ = AC and the firm is making normal profit

• In the long-run, firms in monopolistic competition always make normal profit

  • Firms making a loss leave the industry

  • Firms making supernormal profit see it slowly eradicated as new firms join the industry