Firms that operate under monopolistic competition share some of the characteristics of monopoly and perfect competition. While monopolistically competitive firms operate in highly competitive markets they can set their own, unique price because their offer differentiated products. For example, a local plumber can set a higher price than another local plumber simply because they are prepared to undertake emergency repair work at any time of the day or night.
How firms differentiate when operating under monopolistic competition depends on the nature of the market and the good or service being produced.
For firms producing physical goods, there are multiple ways of employing physical product differentiation. For example, a small furniture maker could differentiate from rivals by using different designs and styles, different materials and methods of construction, and different methods of delivery or payment options for customers.
Producers can also differentiate in the way they use marketing, and in the level of service they provide and the convenience of their business to the customer. For example, hairdressers could open at different times, offer customer parking, and provide drinks and shower facilities, and whether they do home visits.
In the short run, the firm can exploit its position by making super-normal profits.
Super-normal profits will be maximised at the output where marginal revenue equals marginal cost.
In the long-run, excessive profit is not sustainable because new firms will be attracted into the market. This increases the level of competition between existing firms.
Some consumers will switch to these new entrants, and demand for the products of existing firms will fall. Graphically, the AR (demand) curve will shift to the left. If, for some firms, this shift means that, at profit maximisation (where MR = MC), AVC is greater than AR, they will shut down. In the long run, AR must at least cover ATC (breakeven) to enable the firm to continue in business.
In essence, if existing firms cannot differentiate effectively, there is a strong probability that they will leave the market.
The process of new firms entering in the pursuit of super-normal profits - with some being forced to leave - means that the profit maximising firm, operating where marginal revenue equals marginal cost, only makes normal profits, at price P1, where AR = ATC (the AR curve is at tangent to the ATC curve, at point A.)
This provides the incentive to innovate and increase differentiation, and hence return to making super-normal profits.
In the real world many markets resemble monopolistic competition, including small high street retailers and specialist services such as hairdressers and garage services.
The model helps develop an understand of the performance and decision-making of many real firms, especially small firms in specific markets. For example, the ebb and flow of new restaurants in many towns and cities can be explained with reference to the model of monopolistic competition.
In terms of the wider benefit of monopolistically competitive firms to an economy, and to levels of competition, we can identify the following:
Contestability refers to the ease with which new firms can enter and leave a market.
‘Perfect’ contestability means that there are no entry and exit costs. More barriers means less contestability. Under monopolistic competition there are no significant barriers to entry, therefore markets are relatively contestable and firms find it easy to enter and leave the market. Contestability can help drive down market prices - nearer to the perfectly competitive level.
Differentiation can create diversity, choice, and utility for consumers. For example, a typical high street in a town will have a number of different restaurants from which to choose. This means that consumers can exercise their sovereignty in the way they allocate their income. However, it can be argued that consumers can be confused by so much choice and may experience less satisfaction than when there are fewer choice. The proposition that excessive choice can be sub-optimal was explored by Barry Swartz, in 'The Paradox of Choice' (2003), in which he argued that such a vast array of options makes decision making difficult and can raise the expectations of consumers to unreasonable levels, leaving them dissatisfied once they have made their purchase. In other words, choice can bring problems as well as help solve the economic problem. In addition, choice can lead to consumers using an excessive amount of time searching for a good or service before they make their decision - called search costs.
The firm operating under monopolistic competition is inefficient in both the long and short run. Allocative efficiency exists when price equals marginal cost, but for this firm, price is greater than marginal cost.
Profits are maximised at output ‘Q’ where marginal cost equals marginal revenue.
Productive efficiency occurs where average cost is at its lowest, which is also where average cost equals marginal cost. For this firm average cost is not at its lowest.
We can also see that, in the long run, the firm is also inefficient.
However, monopolistically competitive firms may be dynamically efficient - which means that they may need to innovative to make their products different from those of their rivals. [Dynamic efficiency refers to technological innovation in terms of new products, or new working methods or processes.] For example, retailers may have to develop new ways to attract and retain local custom.
Some differentiation does not create utility but generates unnecessary waste, such as excess packaging. In addition, some advertising can be considered wasteful, and may distort rational decision-making.
There is a tendency for excess capacity because firms can never fully exploit their fixed factors, as mass production is difficult. This means that they are productively inefficient in both the long and short run. However, this may be outweighed by the advantages of diversity and choice.