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 3 types of product differentiation.
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 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 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
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.