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    April 7, 2011

Monopolistic Competition

This page will provide an overview of Monopolistic Competition that can be used both by instructors as reference material, as well as students for overview purposes.

Monopolistic Competition (MC) is a market structure that can be characterized by the following properties:

  • there are many competing producers in an industry
  • each producer sells a differentiated product
  • there is free entry into and exit from the industry in the long run

  • Many Sellers: There are many sellers in this market structure, and they are all in competition with each other. Examples may include all food vendors in a food court, several gas stations along a major highway and so forth.
  • Differentiated Product: Since it is next to impossible to have tacit collusion with many sellers, the only way that MC market sellers can gain market share and power is with product differentiation. Consumers view each of the seller’s products as somewhat different from each other. This gives each seller some control to set their own price. Example of product differentiation can be seen in the case of food court, where each vendor is selling a different cuisine, so even though they are all food they are different from each other. So they can charge what they want to for their products.
  • Free Entry and Exit: MC market firms are free to enter and exit the market when they want to. Existing sellers may exit the market if they cannot cover their cost in the long run. New sellers can enter the market if they have new products to sell that consumers are willing to buy.

Product Differentiation:

There are 3 types of product differentiation.

  •   Differentiation by style or type – sedans vs. SUV
  • Differentiation by location – dry cleaner near home vs. cheaper dry cleaner far away
  • Differentiation by quality – ordinary ($) vs. gourmet chocolate ($$$)

Understanding the Market:

Monopolistic Competition (MC) embodies certain characteristics of both perfect competition and monopoly market. Since there are many sellers and each are competing with each other for the same market, along with free entry and exit, MC resembles perfect competition. However, each firm has differentiated product which gives each firm market power and a downward sloping demand curve, so they can be price-makers and thus operate like a monopoly. Combining the two different markets characteristics, we can write the profit maximizing condition for Monopolistic Competition as follows:

Profit maximizing condition is: MC=MR, and charge price at the downward sloping demand line. Since the market faces a downward sloping demand curve, they also face a downward sloping Marginal Revenue curve.

In the long run, since there is free entry and exit, the firms earn zero economic profit. This is the case because, if the market has positive economic profit, new firms will start entering the market, shifting the demand curves of exiting firms to the left, decreasing their quantity, and thus eroding the positive profit. If there is a loss, the firms will exit the market until only firms that can cover the cost stay in the market. So in the long run the Monopolistic Competition only has zero economic profit. The demand curve is just tangent to the average total cost in the long run. The figure for long run is given below

Figure 1

Figure Caption: Figure 1: The Long-Run Zero-Profit Equilibrium

If existing firms are profitable, entry will occur and shift each existing firm’s demand curve leftward. If existing firms are unprofitable, each remaining firm’s demand curve shifts rightward as some firms exit the industry. Entry and exit will cease when every existing firm makes zero profit at its profit-maximizing quantity. So, in long-run zero-profit equilibrium, the demand curve of each firm is tangent to its average total cost curve at its profit-maximizing quantity: at the profit maximizing quantity, QMC, price, PMC, equals average total cost, ATCMC. A monopolistically competitive firm is like a monopolist without monopoly profits.

In the short run, there could be two possible scenarios in the market. There could be a case where the market is experiencing positive economic profit and another where it is experiencing negative economic profit or what we call loss. The figure for short run is given below portraying both possible scenarios:

Figure 2

Figure Caption: Figure 2: The Monopolistically Competitive Firm in the Short Run

The firm in panel (a) can be profitable for some output quantities: the quantities for which its average total cost curve, ATC, lies below its demand curve, DP. The profit-maximizing output quantity is QP, the output at which marginal revenue, MRP, is equal to marginal cost, MC. The firm charges price PP and earns a profit, represented by the area of the green shaded rectangle. The firm in panel (b), however, can never be profitable because its average total cost curve lies above its demand curve, DU, for every output quantity. The best that it can do if it produces at all is to produce quantity QU and charge price PU. This generates a loss, indicated by the area of the yellow shaded rectangle. Any other output quantity results in a greater loss.

Some Practice problems may be found in the section market practice problems.

Reference: Microeconomics, 2nd edition, Krugman & Wells, and also reference material supplementary to the book.