3.4.3 Monopolistic Competition (Edexcel)

This Edexcel study note covers Monopolistic Competition

a) Characteristics of Monopolistically Competitive Markets:

Monopolistic competition is a market structure that combines elements of both monopoly and perfect competition. Here are the key characteristics of monopolistically competitive markets:

1. Many Sellers: There are numerous firms in the market, each producing slightly differentiated products. These differences can be based on branding, quality, design, or other factors.
2. Product Differentiation: Each firm produces a product that is similar but not identical to the products of its competitors. This product differentiation allows firms to have some control over the price they charge.
3. Easy Entry and Exit: Firms can enter or exit the market relatively easily. There are no significant barriers to entry, such as high startup costs or government regulations.
4. Non-Price Competition: Firms engage in non-price competition to attract customers. This includes advertising, product design, branding, and customer service.
5. Limited Price Control: While firms have some degree of pricing power due to product differentiation, they face competition from other firms offering similar products. As a result, they cannot significantly raise prices without losing customers.
6. Short-Run and Long-Run Profits: In the short run, firms may earn economic profits or incur losses. In the long run, however, economic profits tend to be eroded as new firms enter the market or existing firms adjust their products and strategies.
7. Imperfect Information: Consumers may not have perfect information about all available products, making advertising and branding important tools for firms to differentiate their products.

b) Profit Maximizing Equilibrium in the Short Run and Long Run:

Short Run: In the short run, a monopolistically competitive firm maximizes its profit by producing the quantity of output where marginal cost (MC) equals marginal revenue (MR), and setting a price based on its perceived demand curve. Here's how it works:

1. Determine the marginal cost (MC) and marginal revenue (MR) for the firm.
2. Find the quantity of output where MC equals MR.
3. Set the price based on the demand curve corresponding to that quantity.

If the price exceeds average total cost (ATC) at this profit-maximizing quantity, the firm will earn economic profit. If the price is less than ATC but greater than AVC (average variable cost), the firm will incur losses but continue to produce in the short run. If the price falls below AVC, the firm will shut down temporarily.

Long Run: In the long run, monopolistically competitive firms face competition and have the flexibility to adjust their product characteristics, prices, and production levels. Here's what happens in the long run:

1. If a firm is making economic profits, new firms will be attracted to the market due to its attractiveness. This will increase competition.
2. As more firms enter, the demand for each individual firm's product decreases, leading to a decrease in the demand curve for each firm.
3. In the long run, the firm's economic profit will be reduced to zero as the demand curve shifts to the left.
4. Firms may continue to operate with zero economic profit, as long as they cover their average total costs (ATC).
5. If firms are experiencing losses, some may exit the market, and the remaining firms may experience a smaller decrease in demand, allowing them to cover their costs.

In summary, monopolistically competitive firms can earn profits or incur losses in the short run, but in the long run, competition tends to erode economic profits, leading to a situation where firms earn zero economic profit but continue to operate as long as they cover their costs.