Monopolistic Competition

Question 1

Why does competition exist?

Answer 1

There are at least two firms in the industry

Question 2

What is the main difference between perfect and imperfect competition?

Answer 2

They sell non-identical products

Question 3

Why is competition imperfect?

Answer 3

Firms sell products that are non-identical to rivals

Question 4

Assumptions of monopolistic competition

Answer 4

1. Differentiated products
- products are not homogeneous but heterogeneous
- degree of brand loyalty which is why firms advertised their goods and develop them even more

2. Many buyers and sellers
- no one firm is really large in the industry
- there are a lot of firms buying and selling products
- not a lot of substitutes as firms are making different products

3. No barriers to entry or exit
- very easy to enter this particular industry
- if one industry was making supernormal profits, outside firms can easily join the industry and also makes supernormal profits

4. Profit Maximising
- firms operate where MC = MR

Question 5

Why is the demand curve elastic?

Answer 5

• Monopolistically competitive firm is a price maker because of the differentiated products and brand loyalty
• If they were to increase price, they would lose consumers as they offer different services
• the demand curve is downwards sloping but elastic

Question 6

What will the elasticity of demand be?

Answer 6

will be elastic because large number of firms in the industry and producing relatively close substitutes

Question 7

What is small changes in price likely to result in?

Answer 7

result in relatively large changes in quantity demanded as consumers can just switch to substitutes

Question 8

Long run equilibrium

Answer 8

• Output is where MC = MR
• The firm will charge a price on the demand curve
• In the long run, no supernormal profit made

Question 9

How do monopolistic competition firms compete?

Answer 9

• Making their products as distinctive as possible to increase consumer loyalty
• Through advertising and improved quality
• Do this to reduce the substitutability of their goods to make their demand curve as inelastic as possible to increase customer loyalty

Question 10

Why is supernormal profit eliminated in the long run?

Answer 10

• It is possible for firms to make a supernormal profit in the short run
• However, in the short run firms make a lot of super normal profits, which incentivises outside firms to enter the industry as it is more profitable
• shifts the supply curve to the right
• Now more firms in the industry which means that each firm has less demand causing AR to shift downward
• This means that now in the long run, prices are lower and that there is no super normal profit being made

Question 11

Why is this a useful advantage of monopolistic competition?

Answer 11

Shows that even if firms are charging higher, eventually prices will come down in the long run

Question 12

Efficiency Implications

Answer 12

1. Productive inefficiency
- lots of firms in the industry but not large enough to benefit from economies of scale
- Not operating at the MES so prices are not the minimum

2. Allocative inefficiency
- price is not equal to marginal costs but greater
- due to differentiated products which cost more for consumers as costly to produce

3. Dynamic efficiency
- dont make any supernormal profit so dont have enough money to invest into R&D and improve quality
- however, firms may have an incentive to differentiate products to gain more market power and attract consumers

4. X-efficiency
- can’t afford to slack as they are going to make an economic loss

Question 13

Consumer Implications

Answer 13

1. Low prices
- higher prices than perfect competition as selling differentiated products
- lower prices than a monopoly as lots of firms selling goods

2. High quality
- have differentiated products which need to be high quality to remain competitive
- less substitutes
- no supernormal profit made so dont have the money to invest in R&D

3. High Choice
- lots of choice as lots of firms selling different products

Question 14

Advantages of monopolistic competition

Answer 14

1. Lower prices
- prices will come down eventuallu even if charge higher
- prices are lower than a monopoly as not the only firm

2. Lots of innovation and high quality
- lots of firms in the industry so to make curve less elastic they decrease the substitutability of their goods by differentiating their products
- increase consumer loyalty

3. High level of choice
- Large number of firms to buy from
- lots of differentiated goods

Question 15

Disadvantages of monopolistic competition

Answer 15

1. High prices
- higher prices compared to perfect competition as products are differentiated

2. No dynamic efficiency
- no supernormal profit being made so cant invest into research and development
- low quality goods

3. No productive or allocative efficiency
- loads of firms in the industry that are not large enough to benefit from economies of scale
- prices greater than marginal costs due to differentiated products