Market Power & Monopolistic Competition (DP IB Economics)

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

• 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 (P_E ) <  AC at the profit maximisation level of output (Q_E) 
 

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) < 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