3.4.3 Monopolistic competition

Question 1

Monopolistic competition

Answer 1

• Form of imperfect competition where there are many producers competing against each other, but selling products that are differentiated from one another and hence are not perfect substitutes.
  Monopolistic competition is a form of imperfect competition, with a downward sloping demand curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely exist in a pure form in real life. Some examples of firms in monopolistic competition are ​hairdressers, estate agents and restaurants.

Question 2

Characteristics of monopolistic competition

Answer 2

Large number of buyers and sellers
No barriers of entry/exit
Differentiated (non-homogenous) goods

Question 3

Large number of buyers and sellers (monopolistic competition)

Answer 3

There must be a ​large number of buyers and sellers in the market, each of whom are relatively small and act independently. This means that no one buyer/seller has a large price setting power.

Question 4

No barriers to entry/exit (monopolistic competition)

Answer 4

Allows new firms to enter when supernormal profits are being made and some to leave in the case of losses. As a result, only normal profits can be made in the long run.
(Like in perfectly competitive markets)

Question 5

Differentiated goods/services

Answer 5

The difference between perfect and monopolistic goods (other than being more realistic) is that in monopolistic competition firms produce ​differentiated, non-homogenous goods or services.
This means that individual firms do have some price setting power, and so the curve is downward sloping.

Question 6

Profit maximising equilibrium in the short-run (monopolistic competition)

Answer 6

In the short run, firms can make supernormal profits, losses or normal profits.

Question 7

Profit maximising in the long-run (monopolistic competition)

Answer 7

Due to the lack of barriers to entry/exit, firms can only make normal profits in the long run.

Question 8

Efficiency in monopolistic competition

Answer 8

● Since they can only make normal profit in the long run, AC=AR and since they profit maximise, MR=MC. Therefore, the firm will ​not be allocatively or productively efficient, ​as MR does not equal AR so AC cannot equal MC and AC cannot equal MR.
● They are likely to be ​dynamically efficient since there are differentiated products and so know that innovative products will give them an edge over their competitors and enable them to make supernormal profits in the short run. However, since the firms are small they may struggle to receive finance or have the retained profits necessary to invest.
● In monopolistic competition compared to perfect competition, ​less is sold at a higher price and firms may not necessarily be producing at the lowest cost. However, the market will offer ​greater variety and may be able to enjoy some degree of ​economies of scale.

Question 9

Limitation on monopolistic competition model (evaluation)

Answer 9

The limitation of this model is that information may be imperfect and so firms will not enter the market as predicted as they are unaware of the existence of abnormal profits. Also, firms are likely to be different in their size and cost structure as well as in their products, which may allow some firms to maintain supernormal profits because firms cannot compete on equal terms.