3.4.3 Monopolistic competition

monopolistic

market structure in which there are many firms offering a similar product but with some product differentation e.g. nail salons

characteristics of monopolistic competition

• large numbers of small firms

• low barriers to entry and exit from industry

• products slightly diffeentiated

• low degree of market power and some price setting ability

objective of monopolistic competition

to profit maximis so mc=mr

what is the firm with price in monopolistic competition

price maker as they have a differentiated product that is desirable by certain consumers

price maker

firm with market power that is able to manipulate prices in order to change demand

profit in short run

• able to make supernormal profit

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

• 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

short run profit monopolistic competition diagram

• diagram shows output leading to profit maximising price

• means firm earns supernormal profit-shown by red rectangle

short run loss monopolistic competition diagram

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 =

why do supernormal profits become normal in long run

• 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

losses to normal profit monopolistic competition in long run

• 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

long run monopolistic competition diagram

• demand curve shifts left as overall demand split between more firms as more firms

• new enetrants will continue to join until

• only normal profit is earned,at this point the slopes of the AC curve and demand/AR curve touch tangentially shown by red dot

• at this quanity mr =mc blue dot

prices in monopolistic compeition

The short run position of monopolistic competition is basically the same as in a monopoly. However, unlike in a monopoly, new entrants to the market will drive prices down until only normal profit is earned in the long run.

• Exactly how long this process takes is important.

  • If it takes a very long time, the market will resemble a monopoly.

  • But if it all happens relatively quickly, then the market will be more like a perfectly competitive market.

  • This is why firms are often willing to spend large amounts of money to try to differentiate their product (e.g. by improving it or by advertising to create a strong brand). The longer a firm can retain its price-making power, the longer it can make supernormal profit.

But unlike in perfect competition, in monopolistic competition the firm is not producing at the lowest point on the AC curve.

These different positions on the AC curve mean that prices in monopolistic competition tend to be higher than in perfect competition.

This is because firms in monopolistic competition need to spend money on differentiating their product (e.g. by advertising) and creating brand loyalty.

Firms in monopolistic competition have also chosen to restrict output in order to maximise profits. This means they don’t benefit from all the economies of scale that they could.

Prices in monopolistic competition tend to be lower than those charged by a monopoly seller.

efficiency in monoolistic competition

• not allocatively or productively efficient

• dynamically efficient

why is monopolistic competition not productively efficient

not producing at lowest point on ac curve

why is monopolistic competition not allocatively efficeient

equilbrium price greater than mc

why is monopolistic competition it dynamically efficient

differentiated products ans so know innovative products will give them an edge over competitors and enable them to make supernormal profits in short run however sinces firms are small they may struggle to receive finance or have retained profits to invest