4.1.5.4 Monopolistic Competition

monopolistic competition

a market structure with many firms selling similar, but differentiated products where each firms has some price-setting power but faces relatively free entry and exit that drives long-run profit to normal levels.

many firms/consumers(low concentration ratio), freedom of entry and exit(low barriers to entry/exit), producers have some control over prices but limited, similar but differentiated products

features of Monopolistic comeptition

restaurants, hairdressers, coffee shops

application for monopolistic competition

compete on quality as much as food, product differentiation is key for business, low barriers to entry

Why are restaurants an example of monopolistic competition?

a service which will gives firms a reputation for quality

Why are hairdressers an example of monopolistic competition?

other firms in the market produce partial not perfect substitutes, more elastic demand than in a pure monopoly

In the short-run, why are monopolistic firms able to make abnormal profit?

low barriers to entry increases competition which decreases a firm’s demand, hence the firm’s abnormal profit is reduced to normal profit

In the long-run, why are monopolistic firms unable to make abnormal profit?

allocative, productive, dynamic

What kind of efficiencies do monopolistically competitive markets achieve?

allocative efficiency

this occurs when the price of a good equals the marginal cost production(P=MC), meaning resources are allocated in the most socially optimal way

productive efficiency

this happens when firms produce at the lowest point on their average cost curve(i.e. where marginal cost equals average cost, MC = AC)

dynamic efficiency 

This refers to the ability of a market to innovate and improve over time through investment in research and development(R&D). This requires abnormal profits to finance innovation over time.

all firms hold some degree of market power allowing them to charge a price above MC(P>MC)

Why is allocative efficiency never achieved in monopolistically competitive markets?

firms face excess capacity by operating on the downward sloping portion of their AC curve, so they aren’t producing at the minimum possible cost

Why is productive efficiency never achieved in monopolistically competitive markets?

some level of innovation by firms seeking to differentiate products but minimal abnormal profit limits firm’s ability to reinvest in significant innovation

How is dynamic efficiency achieved in monopolistic markets?