Monopolistic Competition

Assumptions of the model

1. There are a large number of firms: This assumption is similar to that of perfect competition, where the large number
of firms ensures that each firm has a small share of the market, and that each firm acts independently of the others.
This also ensures that collusion between firms is not possible.
2. Freedom of entry and exit: The market is characterized by little or no barriers to entry and exit meaning that any
firm can enter and leave the market at any point in time.
3. Product differentiation: The firms sell similar but not identical products. Product differentiation can be on basis of
physical differences, quality differences, location, services and product image.
4. Imperfect information: Unlike perfect competition where buyers and sellers have perfect information, in
monopolistically competitive market information is imperfect which means that buyers and sellers do not have
accessed to all information that will help them to make the best possible decisions.

AR and MR curves of the monopolistically competitive firm

Given the availability of close substitutes in the monopolistic markets it means that the demand curve of the firm will be
downward sloping and elastic. The demand curve is not perfectly elastic because the substitutes are not perfect
substitutes.
On the other hand, because of the downward sloping nature of the demand curve, the MR curve will lie below it.

Equilibrium of the monopolistically competitive firm in the short run

The short run equilibrium position of the monopolistically competitive firm will be similar to that of the monopoly firm
except that the demand curve will be flatter (fairly elastic). In the short run the firm can make either abnormal profit or
losses subject to the profit maximization condition (MR=MC) as illustrated in the diagrams below:

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1. Abnormal profit (AR > AC)

2. Losses (AR<AC)

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 Long Run Equilibrium of the Monopolistically Competitive Firm
The assumption of free entry and exit of firms in the industry is of crucial importance in determining the long run
equilibrium position of the firm.

In the long run, industries in which firms earn economic profits will attract new entrants, while loss making firms in
unprofitable industries will shut down their plants and leave the industry. The process of entry and exit of firms in
the long run ensures that economic profit or loss is zero and all firms earn only normal profits.

If the firm was making abnormal profits in the short run, this will attract new entrants in the long run. The market
share of existing firms will decrease thus shifting their demand curve to the left. Firms will continue to enter and the
demand curve facing them will keep shifting to the left until it reaches the point where it is tangent to the AC curve.
Here the firms will earn only normal profits and entry of new firms into the industry will stop. Note that at that point
MC will also be equal to MR.

On the other hand, the presence of losses in the short run will make some firms shit down completely and leave the
industry. As they do so, their customers will switch their purchases to the remaining firms, which will experience an
increase in demand for their product. This will show up as a rightward shift of the demand curve facing them, and
this process will continue until losses disappear and firms are earning normal profit. As before, this will occur when
the demand curve is tangent to the AC curve, so that at the level of output where MR=MC, P=ATC, and economic
profit is zero.

The long run equilibrium of the monopolistically competitive firm is illustrated in the diagram below:

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 Price and non price competition under monopolistic competition
Price competition among firm occurs when a firm lowers its price to attract more consumers away from rival firms,
and thereby increase its sales at the expense of other firms.
Non price competition, by contrast, occurs when firms use methods other than price reductions in order to attract
consumers. The most common forms of non price competition are product differentiation, advertising and branding.
Monopolistically competitive firms compete with each other on the basis of both price and non price competition.
The more successful they are in increasing their sales and market share through non price competition methods, the
less they need to rely on price competition. By contrast, firms that are less able to achieve consumer loyalty for their
product, and whose product is less differentiated from substitutes, may have to rely more on price competition in
order to increase sales.

Advantages of monopolistically competitive market

1. Competition and costs: Competition between firms under monopolistic competition puts a downward pressure
on costs as firms compete with each other; these competitive pressures may force less efficient firms to leave
the industry.
2. Competition and prices: Free entry and exit of firms drive economic profits to zero in the long run, and allows
price to be lower for consumers than is possible under monopoly, where barriers to entry allow firms to
maintain their abnormal profits in the long run.
3. Product variety: Firms under monopolistic competition goes to great length to differentiate their products. This
is an advantage to the consumers who have accessed to a wider choice as compared to perfect competition and
monopoly.

Limitations of monopolistically competitive market

1. Allocative and productive inefficiency: In both the short run and long the conditions of economic efficiency are
not satisfied. In the short run the firm is both allocatively inefficient (P>MC) as well as productively inefficient
(P≠AC). In the long run, only the condition of productive efficiency is satisfied.
2. Excess capacity: A firm’s capacity output is that output at which AC is at minimum. The monopolistically
competitive firm produces on the downward sloping part of its AC curve in both the short run and long run. This
means that its actual output is different from its capacity output. This difference is known as excess capacity
which is the output lost when firms underuse their plant capacity and produces at a level of output that does
not minimize AC. If firms produce at their minimum AC, fewer firms would produce the industry’s output and
the costs to society would have been lower.
3. Advertising expenditure: Firms may spend huge amount of money on advertising and this may not necessarily
result in significant market share gains for the firm. Moreover, the advertising is most of the time persuasive
thus creating unnecessary wants in consumers.

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