Monopolistic Competition

Monopolistic Competition is based upon a number of assumptions

• Many buyers and many sellers• No barriers to entry or exit• Differentiated products• Perfect information• Perfect factor mobility

Features• Firms act independently - one firm's pricing actions will only modestly affect

other firms, if at all, since they each have such a small % of the market. • Collusion in this type of market is impossible - too many firms to assure

any agreements can be maintained. • Profits – Due to the absence of barriers to entry firms operating under

monopolistic competition will only make normal profits in the long-run although it is possible to make abnormal profits in the short-run.

• Demand Curve – The demand curve facing a monopolistically competitive firm is downward sloping as in order to sell additional units of output, a monopolistically competitive firm must lower the price of all previous units. Demand is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes however it is less elastic than in perfect competition, because the seller’s product is differentiated from its rivals, so the firm has some control over price.

• Advertising – This is widely used to increase the demand for an individual firms product and make it less elastic. However, it tends to be small scale and local rather than national advertising campaigns.

• Differentiated products means there is likely to be some degree of brand loyalty

• Firms have some element of interdependence when deciding price, ‘price makers’ to a certain extent because a number of close substitutes exist

• Firms engage in non- price competition• Hence firms in monopolistic

competition face a downward sloping demand curve

Short- Run Abnormal Profit in Monopolistic Competition

Cost/ Price

Output

MC

AC

D= AR

MR

Pa

bc

q

Long-run Making Normal Profit

In the long-run new firms will enter the market as abnormal profits were being made and the demand facing each individual firm will drop. Demand will fall up until the point where AR (D) = AC and only normal profits are being made.

Cost/ Price

Output

MC

D= AR

MR

c= Pa

AC

q

Short-Run Losses in Monopolistic competition

• Illustrate.

Cost/ Price

Output

MC

D= AR

MR

Pa

AC

cd

q

Long- run equilibrium

• Due to freedom of entry and exit, if abnormal profits exist, new firms enter the industry, shifting the demand curve for existing firms to the left.

• If losses exist, firms will leave the industry, shifting the demand curve for existing firms to the right

• Normal profits will be made in the long run.

Productive and Allocative Efficiency in Monopolistic

Competition• Recall the short run position of a

Monopolistically Competitive Firm making an abnormal profit

• What are the productive and allocative efficient levels of output?

Cost/ Price

Output

MC

AC

D= AR

MR

Pa

bc

q

• And for the short- run making a loss?

Cost/ Price

Output

MC

D= AR

MR

Pa

AC

cd

q

• And for the long- run equilibrium?

Cost/ Price

Output

MC

D= AR

MR

c= Pa

AC

q

Conclusion

• Unlike PC, where in the l/r firms are profit maximisers, productively and allocatively efficient, in monopolistic competition, firms, although maximising profits are neither productively or allocatively efficient.