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Microeconomics: monopolistic competition

Monopolistic Competition:

It is a market structure that has similarities with both perfect competition and monopoly.

  • Similarities with perfect competition:
    • There are multiple firms competing against each other. One common example is fast food chain restaurants.
    • Low barriers to entry. Therefore a firm can easily enter a monopolistic competitive market.   
    • In the short run, firms can earn an economic profit. In the long run, the economic profit attracts other firms up until the economic profit disappear. 
  • Similarities with monopoly:
    • Monopolistic competitive firms have the ability to set a price for their products, though changing prices affects quantity sold proportionally more than for a monopolist.
    • Each firm faces a downward-sloping demand curve due to their pricing power, but it is more elastic (i.e flatter) than for a monopolist.
    • Since each firm faces a downward-sloping demand, the marginal revenue is less than demand.
  •  Unique features:
    • In order to earn an economic profit, each firm produces a different products from their competitors. A firm's effort to differentiate its product from other firms is called product differentiation.
    • Firms spend some of their resources on advertising their products. This is done in order to create brand loyalty push the idea that their products is different than the products produced by their competitors.
Monopolistic competition in the short-run:

  • product differentiation allows a monopolistically competitive firm to earn an economic profit in the short run.
  • Product differentiation causes a firm's demand and marginal revenue to be downward sloping.
  • Firms maximize profit when producing at the quantity where the marginal revenue equals marginal cost.
  • Monopolistically competitive firms are inefficient in the short run:
    • Productively inefficient as the quantity produce is not on the lowest point of the average total cost curve.
    • Allocatively inefficient since the price earned is not equal to the marginal cost. Thus creating a dead-weight loss in the market.


Monopolistic competition in the long run:


  • As long as P>ATC (i.e positive profit), more firms want to enter the market and compete.
  • As new firms enter the market, demand for existing firm's product decreasing (demand shifts left) until no firms earn a positive economic profit.
  • Unlike in perfect competition, the long run equilibrium is neither productively or allocativelly efficient.
  • Monopolistically-competitive firms do not produce at the lowest point of the ATC. The difference between  the output at the lowest point on the ATC curve and the long run equilibrium output is called excess capacity.


References: 

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