3.4.3 Monopolistic Competition

• The characteristics of monopolistic competition are as follows

1. There are a large number of small firms: each one is relatively small and can act independently of the market
2. There is low barriers to entry & exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition
3. 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. Some consumers want an express service & others want to linger. A relatively homogenous product has now been differentiated
4. There is a low degree of market power & some price setting ability

• 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 does have some market power and is able to influence the price & quantity
  • The firm is a price maker
    • This is due to the fact that they have a differentiated product that is desirable by certain consumers
      
      
• The firm can make supernormal profit in the short-run
  
  
• In the long-run, the firm will return to a long-run equilibrium position in which they make normal profit
  • This is due to inability to defend against new competitors who enter the market & copy the products of existing sellers
  • Firms will attempt to find new ways to differentiate their product to prolong the period of supernormal profit e.g. a barber shop may add in a pool table & beer fridge for their customers to enjoy thus making them different from the competition (for a period of time)

Short-run Profit Maximisation

• Firms in monopolistic competition are able to make supernormal profit in the short-run
  
  
• The AR curve is the demand curve of the firm & 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 supernormal 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 supernormal profit

Short-run Losses

• 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) < AC (C₁)
  • The firm's loss is =
    
    

Moving From Short-run Profit/Loss to the Long-run Equilibrium

From Supernormal to Normal Profit

• If firms in monopolistic competition make supernormal 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
    • It is easy to join the industry
• Supernormal 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 initially 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