Monopolistic competition

Firms that operate under monopolistic competition share some of the characteristics of monopoly and perfect competition.

Key characteristics

Firms can set their own price as they produce differentiated products - this means they are price makers, facing a downward sloping average revenue (or AR) curve – which is also known as the firm’s demand curve.

This makes them similar to monopolies. However, they operate in markets with large number of competitors, which is a chacteristic of a more competitive market.

Marginal revenue, MR, will fall at twice the rate of AR. As there are no significant barriers into the market, many competitors will enter the industry.

Each firm will, however, be able to differentiate its good or service from its rivals, and hence set its own price.

The short run

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. But, excessive profit is not sustainable in the long run.

Monopolistic competition

The long run

In the long-run, new firms will be attracted into the market by the thought of super-normal profits. This increases competition for existing firms. Some consumers will switch to these new entrants, and demand for the products of existing firms will fall.

Existing firms that cannot differentiate themselves will leave the market.

This process continues, so that the ‘marginal’ firm operates just where marginal revenue equals marginal cost, and only makes normal profits, at price P1.

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.

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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.

Example - restaurants

Monopolistic competition

A commonly given example of a firm operating under monopolistic competition is an independent restaurant. Independent restaurants can easily differentiate their food and service from other restaurants.

Differentiation can be accomplished in several ways, including their menu, opening hours, décor, seating and so on.

Differentiation means that they can charge their own price, rather than simply charge a ‘market’ price.

Such restaurants may become highly profitable, but this may encourage new restaurants to open up, which may reduce profits (back to ‘normal’ profits) for the original firm. Any further entry into the market is likely to reduce price, and push firms into making losses.

This, in its turn, provides the incentive for the restaurant to differentiate further.

Check your knowledge

Monopolistic competition

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Perfect competition

More on perfect competition.

Perfect competition

What are the disadvantages of oligopoly?


Why are monopolis regulated?

Game theory

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