4.3 Monopolistic Competition

The characteristics of monopolistic competition

A market in which there are many firms operating, each

producing similar but not identical products, so that there is

some scope for influencing price

Product differentiation

A strategy firms adopt that marks their product as being

different from their competitors

Assumptions of Monopolistic Competition

-There are many producers and many consumers - the industry concentration ratio is low

-Consumers are aware that there are non-price differences among products i.e. there is slight product differentiation so non-price competition is strong and plenty of consumer switching takes place

-Producers have some control over price - they are “price makers” not “price takers” but the price elasticity of demand is higher than it would be under monopoly (the cross-price elasticity is high)

-Barriers to entry and exit are low – this allows producers respond to changing profit signals and means profits are competed away in the long run

Short run Monopolistic Competition curve

-In the short run, profits competing in monopolistic competitive markets can be at any level

-Unlike monopoly, there are little to no barriers to entry

Long run Monopolistic Competition curve

-Short-run supernormal profit attracts new producers with new products and so normal profits only are made in the long run equilibrium i.e. where AR = AC

-As more firms enter the market, the demand curve for any existing firm shifts to the left as consumers opt to buy products offered by new or alternative companies. 

-The demand curve continues to move to the left until it is tangential to the AC curve. 

-At this point, the monopolistically competitive firm is at its profit-maximising level of output (because MR = MC) but is also making only normal profit (because AR = AC)

Efficiency in Monopolistic Competition

-Prices are above marginal cost – meaning that the equilibrium is not allocatively efficient

-Saturation of the market may lead to businesses being unable to exploit fully economies of scale - causing average cost to be higher – therefore not productively efficient

-Critics of heavy spending on marketing and advertising argue that much of this spending is wasteful and an inefficient use of scarce resources. (x-inefficiency)

-Debate over the social costs of packaging and negative externalities is linked to monopolistic competition

Advantages of Monopolistic competition 

—A few barriers to entry for new companies

-Active business environment;

-Customers can obtain a great variety of products and services since the products are differentiated;

-Consumers are informed about goods and services available in the market

Disadvantages of Monopolistic Competition

-An excess waste of resources

-Limited access to economies of scale because of the big number of companies

-Misleading advertising

-Excess of capacity

-A lack of standardised goods

-Inefficient allocation of resources

-Impossibility to obtain abnormal profits