Monopolistic Competition IB Review Notes
Basic Information:
The theory of Monopolistic Competition was developed by American economist, Edward
Chamberlin. At the time, only the theories of perfect competition (market such that no
participants are large enough to have the power to set the price of a homogeneous product) and
monopoly (a market structure in which there is only one producer/seller for a product) existed,
so he decided that a third theory should be created which would sit between the two. He defined
a monopolistically competitive market as a form of market where many competing producers
sell products that are differentiated from one another (that is, the products are similar but because
of differences such as branding, not exactly alike)
Monopolistic Competition is very similar to Perfect Competition; however, some of its
characteristics distinguish them from one another. Some of those characteristics include:

The Industry is made up of a large amount of firms.

The firms are relatively small compared to the size of the industry. One firm’s actions
are completely independent of another firm, although those actions are unlikely to have
great effect on any of its competitors.

The products in the industry are differentiated. It is easy to tell one’s firm product from
another, through brand names, color, appearance, packaging, design, quality of service,
skill level, etc.

Firms are completely free to enter or leave the industry because there is no, or very low
barrier to entry.

Examples of Monopolistically competitive industries include nail salons, car mechanics,
plumbers, & jewelers.
Market Structure:
What is interesting about monopolistic competition is that although it may appear to be a
small difference from the assumptions of perfect competition, there is somewhat of a different
market structure than that of perfect competition. Since the products are differentiated, we will
find that there is some extent of brand loyalty. In other words, some of the consumers will stay
loyal to the product and continue to buy even as price slightly increases. For example, let us say
the Smith family has always called the same plumber every time they had a problem at their
house because they like his services. If that plumber were to increase his prices a bit, the Smith
family would continue to use his services, maybe because they believe that he is more skilled
than other plumbers in the local area. Brand loyalty means that producers have some extent of
independency. Also, because of this, the demand curve faced by a monopolistically competitive
firm is highly, but not perfectly elastic. Going back to what was said about monopolistic
competition sitting in between pure monopoly and perfect competition, the monopolistic
competitor’s demand is more elastic than the demand faced by pure monopoly because
monopolistic competition involves many competitors, and therefore more opportunities for
substitution. Meanwhile, pure monopoly holds no sorts of competition at all. On the other hand,
monopolistic competitors have fewer rivals than pure competitors since in a purely competitive
market, products are identical. Price elasticity of demand faced by monopolistically competitive
firm directly depends on the number of rivals and the degree of product differentiation. The
larger the number of rivals and the weaker the product differentiation, the greater the price
elasticity of each seller’s demand, that is, the closer monopolistic competition will be to pure
competition.
The Short Run:
The monopolistically competitive firm maximizes its profit by producing the output at
which marginal revenue equals marginal cost. However, it is possible that a firm might be
producing at a level that will either end up in profits or losses in the short run.
In the graph on the left, the firm is producing at output level q0 = 2000 and selling at price level
$6 (Point C). Point B represents the point at which all fixed costs (costs such as rent, salaries)
are covered, and therefore illustrates that the firm is not making losses and that all costs are
covered. However, since the average cost curve is below the price at which the firm is selling
(point A), we can conclude that the firm is making economic profits.
In the graph on the right, the firm is producing at output level q1 = 1000 and selling at price level
$6 (Point C). Point B represents the point at which the firm is producing, which is below the
point at which all costs would be covered (Point A). Since the revenue the firm is receiving from
producing a point B is under Average Cost Curve, we can conclude that this firm is making
losses.
The Long Run:
Many wonder how is it that in the long run, a monopolistically competitive firm cannot make
profits or losses. The reason this happens is that when a firm is making profit in a
monopolistically competitive market, other firms will be tempted to enter the market, sensing
that they could be able to make profits as well and since there is no barrier to entry, it would be
easy for them to do so. However, as they do so, the firms that already existing have to deal with
even more competition since the products are only slightly differentiated, and therefore, won’t
make as much profit because of the increasing amount of potential substitution. As more and
more firm enter the market, firms will end up making neither profit nor losses and will therefore
be at a steady level where all costs are covered in the long run.
The same applies with firms making losses. As firms are making losses in a monopolistically
competitive market, some of the existing firms will decide to exist the market which is easy to do
since there is no barrier to exit, sensing that their situation will not get any better. As more and
more firms exit the market, the firms that are remaining will find themselves having less
competition, and therefore less potential substitutes for their products. Consumers will start buy
more of their products, and will by doing so, increase the amount of profit the firms are making.
This will lead to firms being at a steady level of production, with all costs being covered.
A monopolistically competitive market can be summed up as being in between perfect
competition and pure monopoly. It describes relationships between firms such as for example
barber shops, bottles of water companies, and many others. Many see it as being very close to
perfect competition; however, these two do hold characteristics that differentiate them from one
another.
Monopolistic Competition Quiz
1. What is a monopolistically competitive market?
a) A form of market where many competing producers sell products that are
differentiated from one another.
b) A form of market where many competing producers sell products that are
identical to one another.
c) A market in which one company has control over the entire market for a product,
usually because of a barrier to entry such as a technology only available to that
company.
d) A situation in which a particular market is controlled by a small group of firms.
2. Which one of these characteristics does NOT describe a monopolistically competitive
market?
a) The industry is made up of a large amount of firms.
b) The firms are relatively large compared to the size of the industry.
c) The products in the industry are differentiated.
d) Very low, or non-existent barrier to entry
3. True or False: Under Monopolistic Competitive, firms have some market power in that
they have control over price.
a) True
b) False
4. Which of the following correctly describes the profit-maximizing level of output
selected by a monopolistically competitive firm in the short run?
a) Firms will produce their output where marginal cost equals marginal revenue.
b) Firms will produce its output where marginal revenue equals price
c) Firms will produce in the short run rather than shut down as long as price exceeds
average variable cost at their output level.
d) Both a and b are correct
e) Both a and c are correct
f) Both b and c are correct
5. Fill in the blank: The demand curve of a monopolistically competitive firm is equal
to________:
a) Marginal revenue curve
b) Marginal cost curve
c) Average revenue curve
d) Average total cost curve
6. True or False: The demand curve of a monopolistically competitive market is more
elastic than that of a purely competitive market.
a) True
b) False
7. Which of the following is true about long-run profits and losses for monopolistically
competitive firms?
a) Economic profit can be sustained in the long-run because of high barrier to entry.
b) Losses can be sustained in the long-run due to low barrier to entry, driving firms
to enter the market when other firms are making losses.
c) Only normal profit is sustainable in the long-run due to the low barrier to entry
which eliminates any sorts of profit or losses.
d) None of the above
8. Which of these competitive markets does not consist of multiple firms?
a) Oligopoly
b) Pure Competition
c) Monopolistic Competition
d) Pure Monopoly
9. What are the different characteristics that differentiate a monopolistically competitive
market from, a) A purely competitive market and, b) A purely monopolistic market? List
at least three factors.
10. Describe the situations that can take place in the, a) Short Run, and in the, b) Long Run
in terms of profits and losses that can be made in a monopolistically competitive
market. Feel free to use graphs as a part of your answer.