MCO - Monopolistic Competition Lesson

Monopolistic Competition Lesson

Have you ever stopped to consider exactly how many different colors, styles, and brands of jeans are available for purchase? No matter your specific preferences, you are likely to be able to find the perfect pair of jeans just for you! This is due to the market structure in which jean manufacturers operate...monopolistic competition.  

Monopolistic competition, as the name suggests, has characteristics similar to perfect (pure) competition and monopoly.

As you can see, monopolistic competition is similar to perfect competition in that there are a large number of buyers and sellers (though not as many as perfect competition), easy entry and exit, and long run profits are zero.

The key to monopolistic competition is product differentiation. Each firm produces a product that is similar to, yet distinctly different from, the products produced by its competitors in the market. Due to the differentiation, monopolistic competitors have some market power. That is, product differentiation is responsible for the monopoly type price making ability possessed by monopolistic competitors. This gives rise to the need for non-price competition in monopolistic competition. Advertising is an example of non-price competition. If the products are different, firms in monopolistic competition need to make consumers aware of how their products are different in order to persuade consumers to purchase their product over another firm's product.  

Just like a monopoly, the demand curve for a monopolistic competitor is downward sloping and marginal revenue lies below the demand curve. This indicates price must be lowered to sell more. However, the monopolistic competitor's demand curve is more elastic than a monopolist's demand curve because consumers have options (substitutes) for the product. Profit is maximized where marginal revenue equals marginal cost. Because of this, monopolistic competition - like monopoly - will result in an inefficient level of production and some deadweight loss.        

Unlike the monopoly, the monopolistic competitor's graph is drawn separately from the market graph since there are a large number of suppliers in this market structure. The elasticity of the demand curve facing a given monopolistic competitor is based on the degree of product differentiation. (Remember, the monopoly's graph was the market graph because it was the only firm for consumers to buy from - market demand was the monopolist's demand curve - and it was the only firm supplying the good - the market supply curve was the monopolist's supply curve.)

Monopolistic Competition Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

Monopolistic Competition in the Short Run

In the short run, monopolistic competition resembles a monopoly. That is, the firm will seek to produce where MR = MC and charge a price that is found on the demand curve. The short run graph for a monopolistic competitor resembles that of a monopolist.

The first step for any firm is to determine the profit-maximizing level of output. For monopolistic competition, that is found where MR = MC. In each graph, the profit-maximizing level of output is designated as Qmc.  At Qmc, the firm looks at the demand curve to establish price. To determine the type of profit (positive or negative/loss), price (AR) should be compared to ATC at the profit maximizing level of output (Qmc).

Monopolistic Competition in the Long Run

In the long run, a monopolistic competitor behaves like a perfect competitor. That is, the existence of short run profits or losses will result in entry or exit in the industry. Entry and exit result in zero long run economic profit (just like in perfect competition). In the market graph, entry or exit results in the market supply curve shifting either right or left. Entry in the market causes demand at a given monopolistic competitor to decrease until economic profit disappears. Exit from the market causes demand at the remaining monopolistic competitors to increase until economic losses disappear.

When profits exist, as they do in the image above, other firms have the incentive to enter the industry in the long run.

As firms enter the industry, demand at any given firm will decrease, or shift left. This is because some of the consumers who were purchasing at one of the existing firms may now switch their purchases to a new firm, thus reducing demand at the firms that were making a profit. As the demand curve shifts left (along with marginal revenue), the distance between price (AR) and average total cost closes (profit is decreasing). Entry will continue to occur so long as positive economic profit can be made. The entry will continue to lower demand at each firm until eventually, price equals average total cost at the quantity where marginal revenue equals marginal cost. The firm's demand curve will lie just tangent to its average total cost curve at the profit maximizing level of output. So, in the long run, the profit maximizing monopolistic competitor will be producing its profiting maximizing level of output where MR = MC, but economic profit will be zero because AR = ATC at that level of output. The firm is now doing the best it can and the best it can do is breakeven.

 

In the presence of economic losses, firms in the industry have the incentive to exit in the long run.  

As firms exit the industry, demand at any given remaining firm will increase, or shift right. This is because the number of consumers in the market has not changed and those consumers will now move demand to the remaining firms. As the demand curve shifts right (along with marginal revenue), the area of loss begins to disappear as price and ATC come closer together. Firms will continue to exit the market until the demand curve shifts right just far enough to become tangent to ATC (P = ATC) at the profiting maximizing level of output (again, at the quantity where MR = MC).

Monopolistic Competition Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

Excess Cost and Excess Capacity

For monopolistic competition, it is important to note that allocative efficiency is not reached (because P > MC) and productive efficiency is not reached (because it is not producing at minimum ATC). The reduced levels of efficiencies result in the monopolistic competitor resembling a monopoly.  

Let's consider how these two inefficiencies are related by briefly exploring the concepts of excess cost and excess capacity. In perfect competition, long run equilibrium was established where P = MC = min ATC. This meant that allocative and productive efficiencies were attained. In the long run, this is not true of a monopolistic competitor. At the quantity that produces long run equilibrium for a monopolistic competitor, marginal cost is still less than average total cost. The firm is considered to be operating with excess cost. That is, the firm could increase production until marginal cost was equal to average total cost and average total cost would be at a minimum. Furthermore, operating with excess cost implies operating with excess capacity. That means a firm has the potential to expand production, but does not do so because it would not be profitable to the firm.

IMAGES CREATED BY GAVS (Image 1 from freepik.com and modified by GAVS)