What is Monopolistic Competition:

Monopolistic competition is a market structure characterized by many firms

selling products that are similar but not identical, so firms compete on other
factors besides price. Monopolistic competition is sometimes referred to
as Imperfect Competition, because the market structure is between pure
monopoly and pure competition/ perfect competition.

Characteristics of Monopolistic Competition:

There are six characteristics of monopolistic competition (MC):

Product differentiation

Many firms

Easy entry and exit in the long run

Independent decision making

Some degree of market power

Buyers and Sellers do not have perfect information (Imperfect

Information)

Product Differentiation:
MC firms sell products that have real or perceived non-price differences.
However, the differences are not so great as to eliminate other goods as
substitutes. Technically, the cross price elasticity of demand between goods
in such a market is positive. MC goods are best described as close but
imperfect substitutes. The goods perform the same basic functions but have
differences in qualities such as type, style, quality, reputation, appearance,
and location that tend to distinguish them from each other. Location is often
a good differentiator of products. Generally, firms that are more conveniently
located can charge higher prices. Likewise, stores that have extended hours
also provide convenience. For instance, if someone needs cold medicine in

the middle of the night, he may go to a 24-hour drugstore to purchase the

medicine, even if it is at a higher price, since he wants immediate relief.

Many Firms:
There are many firms in each MC product group and many firms on the side
lines prepared to enter the market. A product group is a "collection of similar
products". The fact that there are "many firms" gives each MC firm the
freedom to set prices without engaging in strategic decision making
regarding the prices of other firms and each firm's actions have a negligible
impact on the market. For example, a firm could cut prices and increase
sales without fear that its actions will prompt retaliatory responses from
competitors.
The number of firms an MC market structure will support at market
equilibrium depends on factors such as fixed costs, economies of scale and
the degree of product differentiation. For example, the higher the fixed costs,
the fewer firms the market will support. Also the greater the degree of
product differentiationthe more the firm can separate itself from the pack
the fewer firms there will be at market equilibrium.

Easy Entry & Exit in the Long Run:

Because most firms engaged in monopolistic competition have low capital
requirements, firms can easily enter or exit the market. However, the
amount of investment is generally larger than for perfect competition, since
there is an expense to developing differentiated products and for advertising.
A primary feature of monopolistic competition is the constantly changing
array of products that are competing in the marketplace. Firms must
continually experiment with product, prices, and advertising to see what
yields the greatest profit. Although this leads to productive and allocative
inefficiency, the variety of goods offered more than compensates for this
inefficiency.

With easy entry and exit, firms will enter a market where present firms are
earning an economic profit and will exit the market where firms are losing
money thus, allowing the remaining firms earn a normal profit.

Independent Decision Making:

Each MC firm independently sets the terms of exchange for its product. The
firm gives no consideration to what effect its decision may have on
competitors. The theory is that any action will have such a negligible effect
on the overall market demand that an MC firm can act without fear of
prompting heightened competition.

Market Power:
MC firms have some degree of market power. Market power means that the
firm has control over the terms and conditions of exchange. An MC firm can
raise its prices without losing all its customers. The firm can also lower prices
without triggering a potentially ruinous price war with competitors. The
source of an MC firm's market power is not barriers to entry since they are
low. Rather, an MC firm has market power because it has relatively few
competitors, those competitors do not engage in strategic decision making
and the firms sell differentiated product. Market power also means that an
MC firm faces a downward sloping demand curve. The demand curve is
highly elastic although not "flat".

Imperfect Information:
No sellers or buyers have complete market information, like market demand
or market supply.

Short-Run Analysis of a Monopolistic Competitive

Firm:
In the short run, a monopolistically competitive firm maximizes profit or
minimizes losses by producing that quantity that corresponds to when

marginal revenue equals marginal cost. If average total cost is below the
market price, then the firm will earn an economic profit.
At profit maximization, MC = MR, and output is Q and price P. Given that
price (AR) is above ATC at Q, supernormal profits are possible (area PABC).

Fig.1: Monopolistically Competitive Firm in

Short Run

However, if the average total cost is above the market price, then the firm
will incur losses, which will be equal to the average total cost minus the
market price multiplied by the quantity produced. It will still minimize losses
by producing that quantity where marginal revenue equals marginal cost, but
eventually the firm will either have to reverse the losses, or it will have to
exit the industry.

C
P

Q
Fig.2: Monopolistic Competitive Firm in
Short Run

Long-Run Analysis of a Monopolistically

Competitive Firm:
If the competitive firms in an industry earn an economic profit, then other
firms will enter the same industry, which will reduce the profits of the other
firms. More firms will continue to enter the industry until the firms are
earning only a normal profit.
However, if there are too many firms, then firms will start to incur losses,
especially the inefficient ones, which will cause them to leave the industry.
Consequently, the remaining firms will return to normal profitability. Hence,
the long-run equilibrium for monopolistic competition will equate the market
price to the average total cost, where marginal revenue equals marginal
cost, as shown in the diagram below. Remember, in economics, average total
cost includes a normal profit.

Super-normal profits attract in new entrants, which shifts the demand curve
for existing firm to the left. New entrants continue until only normal profit is
available. At this point, firms have reached their long run equilibrium.

Fig.3: Monopolistically Competitive Firm in

Long Run

Productive and Allocative Efficiency of Monopolistic

Competition:

Excess
Capacity

Fig.4: Excess Capacity of Monopolistically

Competitive Firm in the Long Run

A monopolistically competitive firm is allocatively and productively inefficient

in both the long and short run. There is a tendency for excess capacity
because firms can never fully exploit their fixed factors because mass
production is difficult.
Productive efficiency requires that:

Price = Minimum Average Total Cost

Pure competition can achieve productive efficiency, but most monopolistic
competitive firms do not, since they sell at a price higher than the minimum
average total cost, and would actually lose money selling at their minimum
ATC. To use their excess capacity, they would have to produce a quantity
equal to their minimum ATC, but they would not be able to sell that amount
without lowering their prices, which would either reduce their profits or
actually incur losses.
The monopolistic firm also does not achieve allocative efficiency. Allocative
efficiency requires that:
Price = Marginal Cost
The monopolistic firm exhibits a downward sloping demand curve. That
means that in order to sell more units, it must lower its price, but if it lowers
its price, then it must lower its price on all of its units. Thus, like a monopoly,
marginal revenue continually declines as quantity is increased. The firm
maximizes profits when marginal revenue equals marginal cost, but this only
occurs at a quantity that is less than what a purely competitive firm would
produce, where marginal cost equals market price. The marginal cost curve
will always intersect the marginal revenue curve before it intersects the
demand curve, because as previously stated, at any given quantity, marginal
revenue is always less than the market price. Because of this allocative
inefficiency, some consumers must forgo the product because of its higher
price.
While monopolistic competitive firms achieve neither productive nor
allocative efficiency, they do provide a variety of products. The greater the
differentiation of the products, the greater is the inefficiency. However, this
greater diversity is more likely to satisfy consumer tastes, which leads to a
more desirable market.

Mathematical
Problem:
MC
A monopolistically competitive firm has:
ATC

P = 20000 - 15.6Q
TC = 400000 + 4640 + 10Q2
Find that Long Run Profit = 0 & Excess Capacity = 75
Q1 Q2
MR

Solution:
For long run equilibrium,
Slope of AR = Slope of AC (i)

Q
Fig.5: Monopolistic Competition in Long
Run

Now AC = TC/Q
= 400000Q-1 + 4640 + 10Q2
d
( 400000Q 1 +4640+ 10Q )
dQ

Slope of AC =

= -400000Q-2 + 10
& slope of AR =

AR

d
(2000015.6 Q)
dQ

= -15.6
From equation (i)
-15.6 = -400000Q-2 + 10
or, Q2 = 400000/25.6
or, Q = 125
Again, in the long run, P = AC
= 400000Q-1 + 4640 + 10Q
= 400000/125 + 4640 + 10 X 125
= 9090
Therefore, Long run Profit = TR TC
=PXQ
= 9090 X 125 (400000 + 4640 + 10Q2)

Excess Capacity = (Q2 at MC = AC) (Q1 at LR equilibrium)

Now, MC =

d
( 400000+4640+10 Q2 )
dQ
= 4640 + 20Q

MC = AC
or, 4640 + 20 Q = 400000Q-1 + 4640 + 10Q
or, 10Q2 = 40000
or, Q = 200
Therefore, Excess Capacity = 200 125
= 75