Monopolistic Competition

• Monopolistic competition

  A very interesting real world market structure that is a competitive market but with some characteristics of monopoly
• Characteristics of monopolistic competition

  • Many buyers and sellers in the market
  • Firms sell slightly differentiated goods
  • Firms are price makers but only slightly due to good substitutes available
  • Firms have price elastic demand curves
  • Low barriers to entry and exit
  • Good information of market conditions
  • Firms engage in non-price competition (e.g. branding, advertising, quality)
• Firm behaviour in monopolistic competition

  1. Short run: Firms profit maximize, producing where MR=MC, can make supernormal profits

  2. Long run: New firms enter, demand shifts left, until normal profit is made
• As new firms enter the market


  Demand for individual firms shifts left
• Demand curve shifting left

  Until average revenue equals average cost (normal profit)
• Drawing the long run monopolistic competition diagram

  Draw AR and MR curves

  2. Draw MC curve

  3. Find profit maximizing P and Q

  4. Draw AC curve so it touches AR at the minimum point and MC cuts it
• In the long run, monopolistic competition is allocatively inefficient as price > MC
• In the long run, monopolistic competition is productively inefficient as firms do not produce at minimum AC
• In the long run, monopolistic competition may not achieve dynamic efficiency as there are no supernormal profits to reinvest
• Compared to monopoly

  Monopolistic competition has lower price exploitation and loss of consumer surplus
• Compared to perfect competition


  Consumers may prefer product differentiation even if it leads to some allocative inefficiency
• Compared to perfect competition

  Productive inefficiency may be due to meeting consumer demand for variety rather than exploiting economies of scale
• Compared to monopoly

  Monopolistic competition may achieve more dynamic efficiency through reinvestment of normal profits