Monopolistic Competition (Edexcel A Level Economics A)

Characteristics of Monopolistic Markets

• The characteristics of monopolistic competition are as follows

1. There are a large number of small firms: each one is relatively small and can act independently of the market

2. There is low barriers to entry and exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition

3. The products are slightly differentiated: this structure exists as consumers have different desires e.g. two nail bars differentiate their product through express or pampered service. Some consumers want an express service and others want to linger. A relatively homogenous product has now been differentiated

4. There is a low degree of market power and some price setting ability

Profit Maximising Equilibrium in the Short & Long-run

• In order to maximise profit, firms in monopolistic competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)

• The firm does have some market power and is able to influence the price and quantity

  • The firm is a price maker

    • This is due to the fact that they have a differentiated product that is desirable by certain consumers

• The firm can make supernormal profit in the short-run

• In the long-run, the firm will return to a long-run equilibrium position in which they make normal profit

  • This is due to inability to defend against new competitors who enter the market and copy the products of existing sellers

  • Firms will attempt to find new ways to differentiate their product to prolong the period of supernormal profit e.g. a barber shop may add in a pool table and beer fridge for their customers to enjoy thus making them different from the competition (for a period of time)

Monopolistic Competition Diagrams

Short-run profit maximisation

• Firms in monopolistic competition are able to make supernormal profit in the short-run

• The AR curve is the demand curve of the firm and it is downward sloping

  •  The firm has some market power due to the level of product differentiation that exists

    • To sell an additional unit of output, the firm will have to decrease its price

    • The marginal revenue (MR) curve will fall twice as quickly as the AR

Diagram analysis

• The firm produces at the profit maximisation level of output where MC = MR (Q₁)

  • At this level the AR (P₁) > AC (C₁)

  • The firm is making supernormal profit

Short-run losses

• Firms in monopolistic competition are able to make losses in the short-run
  

Diagram analysis

• The firm produces at the profit maximisation level of output where MC = MR (Q_E)

  • At this level of output, the AR (P_E) < AC (C₁)

  • The firm's loss is =

Moving from short-run profit/loss to the long-run equilibrium

From Supernormal to Normal Profit

• If firms in monopolistic competition make supernormal profit in the short-run, new entrants are attracted to the industry and the number of sellers increases

  • They are incentivised by the opportunity to make supernormal profit

  • There are low barriers to entry

    • It is easy to join the industry

• Supernormal profit will be eroded and the firm will return to the long-run equilibrium position of making normal profit

From Losses to Normal Profit

• If firms in monopolistic competition make losses in the short-run, some will shut down

  • The shut down rule will determine which firms shut down

  • There are low barriers to exit, so it is easy to leave the industry

• For the remaining firms, losses will be eliminated and the firm will return to the long-run equilibrium position of making normal profit

Diagram analysis

• The firm is initially producing at the profit maximisation level of output where MC=MR (Q₁)

• At this level of output P₁ = AC and the firm is making normal profit
  

• In the long-run, firms in monopolistic competition always make normal profit

  • Firms making a loss leave the industry

  • Firms making supernormal profit see it slowly eradicated as new firms join the industry