Monopolistic Competition

Question 1

What is monopolistic competition and what are its key features(3)?

Answer 1

Monopolistic competition is a highly competitive market, but not as competitive as perfect competition. The features are:

1. Large number of buyers & sellers. Each is relatively small and acts independently
2. No firms can dominate the market (low concentration ratios)
3. No barriers to entry/exit

The key difference to perfect competition is that the products are slightly different. This means firms are price setters and can each choose their own price, based on the equality of their product. Typical examples of monopolistically competitive markets include hairdressing, restaurants, etc.

Question 2

What does the short run equilibrium look like in monopolistic competition?

Answer 2

The diagram is exactly the same as for monopolies, but since there are lots of substitute the demand is likely to be fairly elastic.

Diagram:
The Monopoly Model
Qπmax at MC=MR, to determine the price, go up to AR.
Supernormal profit if AC

Question 3

What does the long run equilibrium look like in monopolistic competition?

Answer 3

As there are no (low) barriers to entry the existence of abnormal profits attracts new entrants. As there is no market price this reduces the demand for existing firms and so shifts their AR/MR inwards. This continues until there is no abnormal profit made at any quantity and only normal profit at the profit maximising quantity.

Diagram:
The Monopoly Model
Qπmax at MC=MR, to determine the price, go up to AR.
AC is a parabola, touching AR at Qπmax and MC at its minimum point.

Question 4

How efficient is monopolistic competition?

Answer 4

Monopolistic competition is neither productively nor allocatively efficient in both SR &LR.