3.4.3 Monopolistic competition


    a) Characteristics of monopolistically competitive markets
    Monopolistically competitive market has imperfect competition – firms are short run profit maximisers (due to firms selling differentiated products)
    Firms sell non-homogeneous products due to branding (product differentiation)
    But there are lots of relatively close substitutes (but no perfect substitutes) – makes XED of the goods and services sold high
    Gives rise to varying market structures
    Firms that sell popular differentiated products can charge slightly higher prices than competitors
    • May have some element of control as they can differentiate product from rivals • Close but not perfect substitutes
    The model is based on assumption there are large number of buyers and sellers – relatively small and act independently – each seller has same degree of market power as other sellers, but their market power is relatively weak
    No barriers of entry to and exit from the market
    Since firms have a downward sloping demand curve – they can raise price without losing all of their customers – because firms have some degree of price setting power
    SNP in short run is competed away in long run by new entrants
    • They make normal profit in long run – MR = MC
    Buyers and sellers in a monopolistically competitive market have imperfect information
    • E.g. Indian market run by many small sellers
    Very low market concentration
    Examples of monopolistic competition include hairdressers and regional plumbers
    Most realistic form of market

    Advantages and disadvantages of monopolistically competitive markets:

    b) Profit maximising equilibrium in the short run and long run
    c) Diagrammatic analysis
    In the short run, firms profit maximise at the point MC = MR. The area P1C1AB represents the supernormal profits that firms in a monopolistically competitive market earn in the short run.

    In the long run, new firms enter market since they are attracted by profits that existing firms are making
    This makes demand for the existing firms’ products more price elastic which shifts AR curve (demand curve) to the left
    Only normal profits can be made in the long run. The long run equilibrium point is P1Q1.
    Firms can try and stay in short run by differentiating their products and innovating.



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