Market Power & Monopolistic Competition (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Characteristics of Monopolistic Markets
Market power refers to the ability of a firm to influence and control the conditions in a specific market, allowing them to have a significant impact on price, output, and other market variables
Firms in monopolistic competition have some market power, a slightly higher market share than perfect competition and a low industry concentration ratio
The level of market power is relatively low in monopolistic competition
A monopolistic market structure is one in which there are many firms offering a similar product but with some product differentiation
Examples include
Nail salons
Hairdressing or barber shops
Massage parlours
Fruit and veg stores
Characteristics of Monopolistic Competition
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Nature of the product |
| Degree of efficiency |
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Customer loyalty |
| Type of profit |
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Price taker or maker? |
| Level of market power |
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Barriers to entry |
| Slope of the demand curve |
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Number of firms |
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There is some market failure in monopolistic competition, especially in the short run when firms are making abnormal profits
A side by side Comparison of Monopolistic Competition and a Monopoly
The diagrams are essentially the same, however the monopoly revenue curves are steeper (more inelastic)
The diagram on the left is a monopoly diagram as it has steeper revenue curves and is making abnormal profits
Diagram Analysis
The monopoly market on the left has steeper revenue curves as the demand for the product is price inelastic
There are few or no substitute products
This market is also making abnomal profit in the long run (P > ATC) at profit maximisation level of output (Q1)
The monopolistic market on the right has shallower revenue curves as the demand for their product is more price elastic
There are a large number of substitute products
The market is making normal profit in the long run (P = ATC) at the profit maximisation level of output (Q1)
Abnormal Profit in Monopolistic Competition in the Short-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 can make abnormal profit in the short-run
The average revenue (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
A diagram illustrating a monopolistically competitive firm making abnormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q1)
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 abnormal profit
Losses in Monopolistic Competition in the Short-run
Firms in monopolistic competition are able to make losses in the short-run
A diagram illustrating a monopolistically competitive firm making losses in the short-run as the AR (PE ) < AC at the profit maximisation level of output (QE)
Diagram Analysis
The firm produces at the profit maximisation level of output where MC = MR (QE)
At this level of output, the AR (PE) < ATC (C1)
The firm's loss is =
Normal Profit in Monopolistic Competition in the Long-run
From Abnormal to Normal Profit
If firms in monopolistic competition make abnormal profit in the short-run, new entrants are attracted to the industry & the number of sellers increases
They are incentivised by the opportunity to make supernormal profit
There are low barriers to entry and It is easy to join the industry
Abnormal profit will be eroded & 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 & the firm will return to the long-run equilibrium position of making normal profit
A diagram illustrating the long-run equilibrium position for a monopolistically competitive firm which is making normal profit. AR (P1) = AC at the profit maximisation level of output (Q1)
Diagram Analysis
The firm is producing at the profit maximisation level of output where MC=MR (Q1)
At this level of output P1 = AC & 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
Efficiency in Monopolistic Competition
Due to the more competitive environment, there are higher levels of efficiency in monopolistic competition than in other forms of imperfectively competitive market structures
This is true even when they are making abnormal profits in the short-run
There are also more products/services available for customers
In the long run, there are even higher levels of efficiency
Efficiency in Monopolistic Competition in the Long-run
Diagram Analysis
The firm produces at the profit maximisation level of output where MC=MR
The firm is not productively efficient as AC > MC at this level of output
Productive efficiency would occur where MC=AC
The firm is not allocatively efficient as AR (P) > MC at this level of output
Allocative efficiency would occur where AR=MC
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