3.4.3 monopolistic competition

Question 1

What is monopolistic competition?

Answer 1

A form of imperfect competition found in real-world markets. There is product differentiation so firms have some control over price, and the demand curve slopes downwards.

Question 2

What are the characteristics of monopolistic competition?

Answer 2

• many producers and many consumers, low concentration ratio
• perfect information
• product differentiation
• producers are price makers, PED is quite elastic as there is a high number of substitutes available
• low barriers to entry and exit

Question 3

Where do firms produce at in when they are monopolistically competitive?

Answer 3

They profit maximise at MC = MR

Question 4

Explain short run profit maximisation for monopolistic competition

Answer 4

Firms have downward sloping demand curves due to price setting power and differentiated products. If there are many substitutes, AR is likely to be price elastic. AR slopes downwards, MR is below AR. Firms are assumed to profit maximise at MC = MR. Supernormal profits are made here because AR > AC.

Question 5

Explain long run profit maximisation for monopolistic competition

Answer 5

In the short run, firms may have profits at any level. There are no barriers to entry. If there are supernormal profits, new firms are attracted into the market, so normal profits are made in the long run where AR =AC. As more firms enter the market, the demand curve for existing firms shifts left as consumers may switch to new firms. The demand curve continues to shift left until it touches the AC curve. At this point, the firm is at the profit maximising output (MR=MC) but only makes normal profit (AR=AC).

Question 6

Why may a stable equilibrium not be reached for monopolistic competition?

Answer 6

New products come and go, the market can be in a state of constant flux. Existing products may go through a product life cycle affecting volume and growth of sales. Firms may spend heavily on marketing and innovation to extend the life cycle of a product.

Question 7

What is efficiency like in monopolistic competition?

Answer 7

• not allocatively efficient as prices are above marginal cost
• not productively efficient as businesses are unable to exploit economies of scale, AC will be higher
• heavy spending on marketing/advertising could mean wasteful spending and inefficient use of resources
• good dynamic efficiency as there is extensive consumer choice and innovation