1.5.4: Monopolistic Competition (HL only)

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    Definitions

     

    1. Monopolistic competition is a market structure where there are many sellers producing differentiated products, with no barriers to entry or exit.
    2. 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.

     

    Product differentiation

    • 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.