- Monopolistic competition is a market structure where there are many sellers producing differentiated products, with no barriers to entry or exit.
- Product differentiation is a form of non-price competition where suppliers attempt to make their products different (or perceived to be different) from those of their competitors.
Assumptions of the model
- Made up of large no. of small firms.
- All firms produce differentiated products.
- No barriers to entry and exit.
- Makes normal profits in the long run.
- Products are differentiated by brand name, color, appearance, packaging, design, quality of service, skill levels and other methods.
- Examples include salons, car mechanics and jewellers.
- Brand loyalty is important as firms takes risks, consumers still buy their products due to their image and reputation.
- Brand loyalty → Firms are independent for pricing decisions → Price takers.
Movement from short run to long run in monopoly
1. Short term abnormal profit to normal profit
- When firms make short-run abnormal profits → Others firms will come into the industry → Takes the business activity away from existing firms → Shifts demand curve to the left → Price and cost stays the same → Normal profits.
2. Short term losses to abnormal profit.
- When firms make short-run losses → Firms in the industry starts to leave → Firms that remain will increase demand which should lead to increase in price, making price = cost → Normal profits for the firm.
Productive and allocative efficiency
- Productive efficiency is where MC = AC.
- Allocative efficiency is where MC = AR.
Advantages of monopolistic competition compared to perfect competition
- Monopolies have large economies of scale because of their size
- More variety of choice for consumers due to differentiated products.
Disadvantages of monopolistic competition to perfect competition
- Productively and allocatively inefficient.
- Charge a higher price for lower level of output.