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MONOPOLISTIC
COMPETITION
CHAPTER 10 – ECONOMICS – A COURSE
COMPANION
Blink & Dorton, 2007. p114-118
Introduction to Monopolistic
Competition
• The theory of monopolistic competition was
developed by the American Economist Edward
Chamberlin (1899-1967).
• He was dissatisfied with two extreme theories
that existed at the time – perfect competition
and monopoly.
• He wanted to devise something more realistic
that would sit between the two existing
theories.
What is monopolistically competitive
market?
• In simple terms a monopolistically competitive
market is one with many competing firms
where each firm has a little bit of market part.
• This is why we have the term “monopolistic”
as firms have some ability to set their own
prices.
The assumptions of
monopolistic competition
• The industry is made up of a fairly large
number of firms.
• The firms are small, relative to the size of the
industry. This means that the action of one
firm are unlikely to great effect on any of its
competitors.
• However, they have some control over price.
• The firms assume that they are able to act
independently of each other.
The assumptions of
monopolistic competition
• The firms all produce slightly differentiated
products.
• This means that is possible for a consumer to
tell one firm’s product from another.
• Firms are completely free to enter or leave the
industry. There are no barriers to entry or
exist.
How is Monopolistic Competition
different to Perfect Competition ?
• The major difference from perfect competition, is
that in monopolistic competition, there is
product differentiation.
• In addition, consumers do have perfect
information.
• Product differentiation exists when a good or
service is perceived to be different from other
goods or services in some way.
• Products may be differentiated by brand name,
colour, appearance, packaging design, quality of
service, skill levels and many other methods.
Examples of Monopolistically
Competitive Industries
• Examples of monopolistically competitive
industries are car mechanics, plumbers and
jewellers.
How is the market structure different?
• Although it may appear to be a small
difference from the assumptions of perfect
competition, this leads to a markedly different
market structure.
• As the products are differentiated there will
some extent of brand loyalty.
Brand Loyalty
• Some consumers will be loyal to the product
and continue to buy it if the price goes up
little.
• For example, if my that a customer of a certain
plumber will stay with that plumber, when he
raises prices above local rivals, because they
believe he is slightly more skilled his
competitors.
Brand Loyalty & Price
• Brand loyalty means that producers have
some element of independence when they
are deciding on price.
• They are, to an extent, price makers, and so
they faced a downward sloping demand
curve.
• However, demand will be relatively elastic
since there are many, only slightly different
substitutes.
DEMAND CURVE –
MONOPOLISTIC
COMPETITION
The firm faces a
downward sloping
demand curve with a
marginal revenue
curve that is below it.
It produces so that it
is maximising profits
where MC=MR. This
means that the firm
will produce an
output of q and sell
that output at a price
of P.
SHORT RUN ABNORMAL PROFITS IN MONOPOLISTIC COMPETITION
In this case, the firm is maximising profits by producing
at the level of output where MC=MR, and the cost per
unit (AC) of C is less than the selling price of P. There is
an abnormal profit that is shown by the shaded area.
SHORT RUN ABNORMAL LOSSES IN
MONOPOLISTIC COMPETITION
Once again, in this
diagram the firm is
producing where
MC=MR, but this
this time the cost
per unit, C, is above
the price, P, and the
amount of losses is
shown by the
shaded areas.
Long Run Equilibrium of the firm in
Monopolistic Competition
• Regardless of abnormal profits or losses, there
will be long run equilibrium where all the
firms in the industry are making normal
profits. This is because there is freedom of
entry and exit in the industry.
Long Run Equilibrium of the firm in
Monopolistic Competition
Abnormal Profits attract new Entrants
• If the firms are making short-run abnormal
profits, then other firms will be attracted to
the industry.
• Since there are no barriers to entry it is
possible for other firms to join the industry.
• As they enter they will take business away
from existing firms whose demand curve will
start to shift to the left.
Long Run Equilibrium of the firm in
Monopolistic Competition
Losses leads to firms exiting the industry
• If firms are making short run losses, then
some of the firms in the industry will start to
leave.
• The firms that remain will find that their
demand curves start to shift to the right as
they pick up trade from the leaving firms.
Long Run Equilibrium of the firm in
Monopolistic Competition
Product Differentiation
• When new entrants come into the market,
they will try to distinguish themselves, in a
number of ways.
• This production differentiation is also know as
non-price competition.
LONG RUN EQUILIBIRUM IN
MONOPOLISTIC COMPETITION
All firms are making normal
profits. The firms are
maximising profits by
producing at level of output
where MC = MR and, at that
output, the cost per unit, C,
is equal to the price per
unit, P. Each firm is exactly
covering its costs, including
opportunity costs, and so
there is no incentive for
firms to leave the industry.
Firms outside the industry
will not enter, since they
will be aware that their
entrance would lead to
losses for everyone.
RESTUARANT EXAMPLE OF MONOPOLISTIC COMEPTITION
PRODUCTIVE & ALLOCATIVE EFFICIENCY
IN MONOPOLISTIC COMPETITION
• Productive efficiency is achieved at the level of
output where a firm produces at the lowest
possible cost per unit, the point where AC is at
a minimum. This is the point where MC curve
cuts the AC curve.
• Allocative Efficiency is achieved at the level of
output where the MC curve cuts the AR curve:
the social optimum level of output.
PRODUCTIVE AND ALLOCATIVE EFFICENCY IN THE
SHORT RUN IN MONOPOLISTIC COMPETITION
The graphs above show two possible short run positions in
monopolistic competition and abnormal profits and losses. The firm
produces at the level of output where profits are maximised, q, as
opposed to the productively efficient level of output q1 or the
allocatively efficient level of output, q2.
PRODUCTIVE AND ALLOCATIVE EFFICENCY
IN THE LONG RUN
The firm is again
producing at the
profit-maximising
level of output, q,
and not at the
productively efficient
level of output, q1 or
the allocatively
efficient level of
output q2.
Monopolistic Competition in
comparison with Perfect Competition
• Unlike perfect competition, where in the long
run the firms are profit-maximisers,
productively efficient and allocatively efficient,
firms in monopolistic competition, are neither
productively or allocatively efficient.
• Firms in monopolistic competition in the long
run are maximising profit only.
Why is productive and allocatively efficiency
not achieved with Monopolistic Competition?
• Even though the firm is monopolistic
competition is not allocatively efficient (it
does not produce where MC=AR) and is not
productively efficient (it does not produce
where MC=AC) the inefficiency is not due to
the firm’s ability to restrict output and
increase price as in a monopoly.
• The inefficiency is, in fact, the result of the
consumers desire for variety
Why is productive and allocatively efficiency
not achieved with Monopolistic Competition?
• Although allocative efficiency does not occur,
it is hard to argue that consumers are worse
off with monopolistic competition than with
perfect competition, since the difference is
due entirely to consumer desire to have
differentiated products.
Price & Monopolistic Competition
• Rather than having a perfectly competitive
situation, where consumers pay lower prices,
but are able to purchase a homogenous
product, monopolistic competition give
consumers the opportunity to make choices.
• This is why they are prepared to pay slightly
higher prices for the products.
EXAMINATION QUESTIONS
Short Response Questions
1. With the help of a diagram, explain the level of
output that a profit-maximising firm will produce at in
the long run in monopolistic competition. (10 marks)
2. With the help of a diagram, explain how it is possible
for a firm in monopolistic competition to earn
abnormal profits in the short run.
3. Explain whether or not a firm in monopolist
competition earning abnormal profits is productively
and allocatively efficient.
EXAMINATION QUESTIONS
Essay Questions
1a. Explain the differences between
the assumptions of perfect
competition and monopolistic
competition.
1b. Evaluate the view that it would be
beneficial if all markets were in
perfect competition.