Monopolistic Competition

This section explains Monopolistic Competition and includes: Characteristics of Monopolistically Competitive Markets and Profit Maximising Equilibrium in the Short Run and Long Run.

Monopolistic competition is a market structure that blends features of both perfect competition and monopoly. It describes markets in which many firms compete by selling differentiated products.

Characteristics of Monopolistically Competitive Markets

Monopolistically competitive markets exhibit the following features:

• Many buyers and sellers: No single firm has significant market power.
• Product differentiation: Each firm sells a slightly different product (e.g., through branding, quality, or customer service).
• Freedom of entry and exit: No major barriers to entry or exit in the long run.
• Some price-making power: Due to product differentiation, firms face a downward-sloping demand curve.
• Imperfect information: Consumers may not have perfect knowledge of all products and prices.
• Profit maximisation: Firms aim to produce where MC = MR.

Profit Maximising Equilibrium in the Short Run and Long Run

Short-Run Equilibrium

• Firms can make supernormal profits, normal profits, or losses in the short run.
• Profit is maximised where marginal cost (MC) = marginal revenue (MR).
• If average revenue (AR) > average cost (AC), the firm earns supernormal profit.
• If AR < AC, the firm incurs a loss.

Long-Run Equilibrium

• Due to freedom of entry, supernormal profits attract new firms.
• As more firms enter, each firm's demand curve shifts left (becomes more elastic).
• This continues until only normal profit is made, where AR = AC at the profit-maximising output.
• Firms still produce where MC = MR, but not at the minimum point of the AC curve — indicating productive inefficiency.
• As price > MC, allocative inefficiency also occurs in the long run.

Diagrammatic Analysis

Short-Run Diagram:

• Downward-sloping AR and MR curves, due to product differentiation.
• U-shaped AC and MC curves.
• Profit-maximising output where MC = MR.
• Supernormal profit shown as the vertical gap between AR and AC at that output.

Long-Run Diagram:

• New firms entering the market shift demand left.
• Firm’s AR = AC at the new profit-maximising output.
• Firm earns normal profit only.
• Still produces where MC = MR, but not at minimum AC, showing excess capacity.

Summary

Monopolistic competition reflects many real-world markets, especially in retail and service industries, where firms offer similar but not identical products. While firms have some control over price, long-run competition erodes supernormal profits, leading to inefficiencies compared to perfect competition.