1.5.4: Monopolistic Competition (HL only)
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
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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.