10.2

• Monopolistic competition is a market structure that shares characteristics with both perfect competition and monopoly.
• features of monopolistic competition:

  • many firms
  • product differentiation
  • downward sloping demand curve
  • free entry and exit
• • Many Firms: There are many firms in the market, but each firm produces a differentiated product. Examples include restaurants, hair salons, or local grocery shops.
• Product Differentiation: Products are similar but not identical. Each firm tries to make its product unique through branding, quality, or location, which gives it some control over its prices.
• Downward Sloping Demand Curve: Unlike perfect competition, where firms are price-takers, firms in monopolistic competition face a downward-sloping demand curve. This means they have some degree of pricing power due to product differentiation.
• Free Entry and Exit: In the long run, firms can enter or exit the market freely, similar to perfect competition. This ensures that firms in the long run will make normal profits (zero economic profit).
• The demand curve that the firm faces.

  • It's downward sloping because the firm can set its price, but lowering the price increases the quantity sold.
• • The marginal revenue curve, showing the additional revenue from selling one more unit.
  • It is always below the demand curve because to sell more units, the firm must lower the price not just for the additional unit but for all units sold.
• The marginal cost curve, showing the additional cost of producing one more unit of output.

  • The firm’s optimal output occurs where MC = MR, as this is the profit-maximizing rule for any firm.
• • The average cost curve, showing the cost per unit at each level of output.
  • In the long run, firms enter the market until the firm’s demand curve touches the AC curve, meaning the firm earns zero economic profit.
• Short-Run Profits:

  • The firm maximizes profits by producing at the quantity where MC = MR, which is Q₀ in the graph.
  • The price at Q₀ is set at P₀, determined by the demand curve DD at that quantity.
  • Profit in the short run is the area between P₀ (price) and AC₀ (average cost). It is represented by the shaded area between the average cost curve and the demand curve.
• • In the short run, firms can earn positive economic profits because of product differentiation. The price is higher than the average cost, allowing firms to profit.
• Short-Run Losses:

  • If market conditions worsen or demand shifts left, firms may face losses in the short run. This happens when the average cost curve is above the price level.
• Interpretation: Firms may incur losses if their costs exceed the price consumers are willing to pay, but they may continue to operate in the short run if they can cover their variable costs.
• Zero Economic Profit:

  • In the long run, if firms are making profits, new firms enter the market, shifting the demand curve to the left.
  • Entry continues until each firm’s demand curve is tangent to its average cost curve (AC₁) at point F. This is called the tangency equilibrium.
  • At this point, the firm is still producing at Q₁ where MC = MR, but now P₁ = AC₁.
  • The firm makes zero economic profit, meaning the total revenue covers all costs, including opportunity costs.
• Excess Capacity:

  • In long-run equilibrium, the firm is not producing at the minimum point on its average cost curve. Instead, it is producing less than the quantity that minimizes average costs.
  • This is known as excess capacity, meaning the firm could produce more and lower its average costs, but doing so would not be profitable because it would have to lower prices significantly.
• In monopolistic competition, firms don’t fully exploit economies of scale because of the downward-sloping demand curve. They produce less than what is technically efficient in terms of cost minimization.
• • Firms have some degree of market power because of product differentiation. Even in the long-run equilibrium, price exceeds marginal cost (P₁ > MC), allowing firms to have some control over pricing.
  • However, the market power is limited, as free entry ensures that no firm can earn long-term economic profits.
• Product differentiation is a key feature of monopolistic competition. It refers to the fact that firms in monopolistic competition offer products that are similar but not identical. They compete on aspects like:

  • location
  • quality
• Location: A corner shop can charge slightly higher prices because it is more convenient for local customers than a large supermarket further away.
• 1. Quality: Different restaurants may charge higher prices based on food quality, atmosphere, or customer service.
• The restaurant industry is a classic example of monopolistic competition:

  • There are many restaurants, each offering a unique dining experience (product differentiation).
  • Each restaurant has some control over its pricing because customers are willing to pay more for perceived quality or convenience.
  • In the short run, some restaurants may earn profits, but new restaurants will enter the market until profits are competed away, leading to zero economic profit in the long run.
• • In the short run, firms can earn profits or incur losses.
  • In the long run, free entry and exit ensures that firms make zero economic profit.
• Excess Capacity:

  • Firms in monopolistic competition do not produce at the minimum point of their average cost curve, which leads to excess capacity in the long run.
• Product Differentiation:

  • This gives firms some pricing power, but they are still subject to competition. Differentiation can be based on quality, location, or branding.
• the firm's profit-maximizing rule is to produce where MC = MR.
• The demand curve faced by each firm is downward sloping because of product differentiation.
• In the long-run equilibrium, price equals average cost, but price is still greater than marginal cost