Monopolistic Competition (AQA A Level Economics)

• 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 vegetable stores

Diagram: Monopolistic Competition

Monopolistic competition should not be confused with a monopoly. As a market structure, it sits closer to perfect competition
 

Characteristics of Monopolistic Competition

Characteristic	Explanation	Characteristic	Explanation
Nature of the product	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 - a relatively homogenous product has now been differentiated	Degree of efficiency	More competition pushes the firm to better efficiency   Allocative efficiency in the long-run
Customer loyalty	Relatively low due to number of substitutes However, can also be relatively strong based on client/customer relationship, e.g loyalty to a specific hairdresser	Type of profit	Can be abnormal in the short-run   Normal (breakeven) in the long-run
Price taker or maker?	Some price setting ability	Level of market power	There is a low degree of market power
Barriers to entry	There are 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	Slope of the demand curve	Shallow (elastic)   Same shape as monopoly revenue curves, but those are steeper (more inelastic)
Number of firms	There are a large number of small firms Each one is relatively small and can act independently of the market

   

• 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 average revenue curve (AR)
      
      
• A very good example of how this occurs can be seen in the barber shop industry 
  • Innovators may offer unique features such as free espressos, or child care while you wait
  • This permits them to charge higher prices until such a point as competitors copy their innovative actions
  • Their abnormal profit will then be eroded

Diagram: Short-run Profits for a Monopolistically Competitive Firm

Firms can make supernormal profits 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, AR (P₁) > AC (C₁)
  • The firm is making abnormal profit

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

Diagram: Short-run Losses in Monopolistic Competition

Short-run losses occur as 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 =
    

From Abnormal to Normal Profit

• If firms in monopolistic competition make abnormal 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 and It is easy to join the industry
     
• Abnormal 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: Long-run Equilibrium for a Monopolistically Competitive Firm

The firm is making a 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 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