4.3 Monopolistic competition

• Monopolistically competitive markets


  • Imperfect competition
  • Firms are short run profit maximisers
  • Firms sell non-homogeneous products due to branding (product differentiation)
  • Many relatively close substitutes
  • High cross-price elasticity of demand (XED)
  • Large number of small, independent buyers and sellers
  • Firms have some degree of market power but it is relatively weak
  • Firms compete using non-price competition
  • No barriers to entry or exit
  • Firms have downward sloping demand curve and can raise prices without losing all customers
  • Buyers and sellers have imperfect information
• Examples of monopolistic competition

  • Hairdressers
  • Regional plumbers
• Profit maximising equilibrium in the short run


  1. MC = MR

  2. Supernormal profits (area P1C1AB)
• Profit maximising equilibrium in the long run

  1. New firms enter market

  2. Demand curve (AR) shifts left

  3. Only normal profits can be made (equilibrium at P1Q1)
• Firms can try to stay in the short run

  By differentiating their products and innovating
• Advantages of monopolistic competition

  • Consumers get wide variety of choice
  • Model is more realistic than perfect competition
  • Supernormal profits in short run might increase dynamic efficiency through investment
• Disadvantages of monopolistic competition

  • Firms are allocatively inefficient in short and long run (P > MC)
  • Dynamic efficiency might be limited in long run due to lack of supernormal profits
  • Excess capacity and productive inefficiency in short and long run (firms don't operate at bottom of AC curve)
  • Firms have x-inefficiency and little incentive to minimise costs