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Monopolistic Competition

The theories behind monopolistic competition were devised by Edward Chamberlin and Joan Robinson. It described a market form that shares some characteristics of monopoly and some of perfect competition. In this market there are numerous firms producing similar but not identical products. It is also known as the excess capacity theorem.

The same assumptions are made as under perfect competition except that the products are differentiated.

Product Differentiation
It is assumed that firms differentiate their products and hence will face downward sloping demand curves (one that is less than perfectly elastic despite the amount of competition). Each firm competes by making its product slightly different and thus permitting it to have some influence over the price through brand loyalty. It is common for markets operating under monopolistic competition to advertise heavily.

Freedom of Entry
We assume there is easy entrance into the market. New entrants to the market will attempt to different their product from that of the competition. However there may be high barriers to exits due to the sunk costs of expensive advertising. There is also some contention that arises from this point. Some economists don’t believe you can have easy entrance to the market whilst having to differentiate your product.

Low Concentration
There are many firms operating in the market and hence the concentration ratio for the industry tends to be low. Because of this high competition a price change by one firm won’t have much effect on the demand for its rival’s products. Therefore it is unlikely that firms will interact with each other with regards to price setting.

Short Run Equilibrium
The graph to the left shows a firm operating under monopolistic competition. It will choose to produce at MR=MC and hence will make a short run abnormal profit as shown by the highlighted rectangle. It is possible for a firm to make a loss in the short run and it would only remain in business if the price was greater than the average variable cost (P>AVC).

Long Run Equilibrium
Because we assume free entry into the market any supernormal profits will attract new firms into the market. The new firms (that have entered) will make differentiated products. The effect of this will be to attract customers away from the incumbent firm (and hence cause demand to shift leftwards) and as there are now more substitutes to the original product the demand curve will become more elastic. New firms will continue to enter the market whilst profits exist a process which begins to eliminate profits (by shifting the demand curve, marginal revenue will also fall). This process may be accelerated by firms increasing advertisement in a bid to defend their market share. This will help to keep the demand curve downward sloping (inelastic) but will increase average costs. The graph to the left shows the long run equilibrium when no abnormal profits are being made.
Efficiency of Monopolistic Competition
In the long run neither productive nor allocative efficiency is attained. This is because the price is above the marginal cost meaning the market is allocatively inefficient. Firms in monopolistic competition also produce at a level of output below the minimum of average costs making the productively inefficient this indicates that firms produce at a level less than the optimum capacity.
The shaded triangle shows welfare loss. In the long run the number of firms in monopolistic competition is inefficient as there are too many firms creating externalities.
There is a positive product variety externality as consumers are getting a wider choice of differentiated products. Simultaneously there is a negative business stealing externality arising from new firms pinching customers from incumbent firms.
Advertising can have negative effects by stipulating consumers tastes, promoting brand loyalty and raising the costs for the firm and hence the price for the consumers. Due to the large number of competitors, the firm isn’t producing at its minimum total costs because it can’t produce enough output. If there were fewer firms then the firm could produce more and may reach its minimum point on its average cost curve which would benefit society. However it could be argued that there is a benefit to consumers from the wide range of choice they have. Also the fact that they pay a premium to purchase their favourite brands shows that they prefer it to any substitutes.
It could also be argued that firms operating under monopolistic competition are less likely to be operating at X-inefficiency than monopolies as they try to keep costs down in order to maximise profits.
Page last updated on 20/10/13