3.4.3 Monopolistic competition

Define monopolistic competition.

Monopolistic competition is a form of imperfect competition, with a downward sloping demand curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely exist in a pure form in real life.

Why is competition imperfect?

Firms sell products which are not identical to the products of rival firms

What are the 4 assumptions of a monopolistically competitive market?

• Many small buyers and sellers

• No barriers to entry or exit

• Differentiated products, slightly different

• Short run profit maximisers

Explain the characteristics of a monopolistic competitive market using the takeaway market as an example.

• Assume many small buyers and sellers. Many hungry consumers and lots of sellers of food. In London there are almost 10,000 sellers.

• Low barriers to entry/exit, to enter the takeaway market only need to rent shop cook, some sunk costs but not high such as rent

• Differentiated goods. Similar all takeaway but pizza chips kebab chicken all slightly different

• SR profit max

Illustrate a monopolistic competition diagram in the short run.

Illustrate a monopolistic competition diagram in the long run.

Explain the monopolistic competition diagram reaches long run equilibrium

Due to supernormal profits being made in the short run which incentivises more people to join the market due to low barriers to entry this further encourages people to enter the matjet which increases the volume of firms entering the market. Incumbent firms will start losing customers to new firms. This reduces demand so MR and AR will decrease for the incumbent firm, SNP will be competed away. No more supernormal profits will be produced by the firms in the market so potential suppliers have no reason to enter the market anymore. Now reached LR equilibrium

Is a monopolstic competitive market productive?

No, the level of output is simply too low in monopolistic competition for firms to be productively efficieny. This is a cost of the variety consumers enjoy

Are firms in a monopolistically competitive market allocatively efficient?

NO

• Firms charge a price above marginal cost because they are unable to charge a lower price because of the high costs involved in producing a small amount of differentiated output

Are firms in a monopolistic competitive market dynamically efficient?

YES

• market power of firms comes from their differentation so there is likely to be alot of innovation.

• HOWEVER, due to no SNP in the long run the likelihood is low

Are firms X efficient?

NO

• firms only make a normal profit even when X-efficient so there is no space for slack

Are these features of consumer welfare met?

• Low prices

• High quality products

• High levels of choice

• No prices are NOT low. This is because despite firms not having the market power to exploit consumers there are high costs involved in differentiating products on such a small scale of output

• YES products are high quality. The only thing stopping firms facing perfrctly elastic demand curve is differentaited good, so seek to increase quality of products. However no LR SNP low R+D

• YES high levels of choice many small firms producing heterogeneous products

Evaluate the advantages and disadvantages of monopolistic competiton. [3]