An industry in monopolistic competition is one made up of a large number of small firms who produce goods which are only slightly different from that of all other sellers. It is similar to perfect competition with freedom of entry and exit for firms and any supernormal profits earned in the short-run will be competed away in the long-run as new firms enter the industry and compete away the profits.
Assumptions of monopolistic competition
In monopolistic competition, as with perfect competition, we make a number of assumptions. However, do not get muddled by the word monopolistic in the title. As a form of competition, this is closest to perfect competition and nowhere near the monopoly end of the scale. The reason for the name is that in monopolistic competition we drop the assumption from perfect competition of homogeneity of products and so each firm can develop their own 'brand' of product. This means that each firm has a 'monopoly' over their brand, but there is still a large number of firms.
The main assumptions are:
- Large number of firms - each firm has an insignificantly small share of the market.
- Independence - as a result of a large number of firms in the market, each firm is unlikely to affect its rivals to any great extent. In making decisions it does not have to think about how its rivals will react.
- Freedom of entry - any firm can set up business in this market.
- Product differentiation - each firm produces a different product or service from its rivals. Therefore each firm faces a downward sloping demand curve. This is the key difference from perfect competition. Product differentiation involves creating differences between products, either real or imagined, in consumers minds and is likely to involve various forms of non-price competition such as branding and advertising.
Examples of monopolistic competition
Petrol stations, restaurants, hairdressers and builders are all examples of monopolistic competition. Monopolistic competition is a common form of competition in many areas. A typical feature is that there is only one firm in a particular location. There may be many chip shops in town but only one in a particular street. People may be prepared to pay higher prices than go elsewhere, or they may simply prefer this 'brand' of fish and chips.
Monopolistic competition in the short-run
As with other market structures, profits are maximized in monopolistic competition where MC = MR. The AR and MR curves are more elastic than for a monopolist as there are more substitutes available. The profits depend on the strength of demand, the position and elasticity of the demand curve. In the short run therefore firms may be able to make supernormal profits. This situation is shown in the diagram below.
Monopolistic competition in the long run
In the long run firms will enter the industry attracted by the supernormal profits. This will mean that demand for the product of each firm will fall and the AR (demand curve) will shift to the left. Long run equilibrium occurs where only normal profits are being made as new firms will keep entering as long as there are supernormal profits to be made. In equilibrium, the demand curve (AR) will be tangential to the firm's long run average cost curve as shown in the diagram below.
We can see this change between the short-run and long run clearly if we combine Figures 1 and 2 together. Figure 3 shows the changes taking place as new firms enter the market.
Limitations of model
The monopolistic competition model has various limitations and these include:
- Imperfect information
- Difficulties in deriving the demand curve for the industry as a whole
- Size and cost structure mean that normal and supernormal profits can be made in the long run by firms in the same industry
- The simple model concentrates on price and output. However, in practice, the firm will need to decide the variety of the product and advertising
Efficiency in monopolistic competition
- Monopolistically competitive firms may have higher costs than perfectly competitive firms, but consumers gain from greater diversity
- Monopolistically competitive firms may have fewer economies of scale and conduct less research and development, but competition may keep prices lower than under monopoly
- Neither productive nor allocative efficiency is achieved. AC is not at its minimum in the long run (productive inefficiency) and price is greater than marginal cost (allocative efficiency).