Monopolistic Competition The market structure/model of monopolistic competition is based on the following assumptions: There are no barriers to entry and exit (And therefore  a large number of firms) AND There is product differentiation - not homogenous goods but differentiated by, for example: Quality differences Location Product image Services Examples include restaurants, clothing, shoes, book publishing, processed foods of all kinds, laundry detergent, toothpaste.. It is another type of imperfect market structure

(continue) Market structure combines both elements of perfectly competitive markets and monopoly It resembles perfectly competitive market because there are many firms in the industry and there are free entry and exit It is like monopoly because of product differentiation (single producer of its particular kind/version of the good) and faces a downward sloping demand curve e.g. Adidas is monopoly of Adidas shoes, Nike monopoly of Nike shoes, etc. However, because each of these products is at the same time a substitute for the other, the demand curve facing the firm is relatively more elastic (more horizontal and flat) than in the case of monopoly

More Elastic Demand Curve than Monopoly

Economic Analysis of the Behavior of the Firms in Monopolistic Competition

Profit Maximization in the Short Run The short run equilibrium position of the individual firm in monopolistic competition is identical to that of the monopolist with the only difference being the price elasticity of the demand curve (more flat) The firm applies the profit maximization rule MC = MR and can earn economic profits or losses as shown below

BUT…………. in the Long Run The assumption of free entry and exit of firms-  ……………………………………………..if existing firms are making a positive (abnormal) profit 

 Final LR Equilibrium

Efficiency Analysis of the Monopolistic Competition Outcomes

Efficiency vs……………… In monopolistic competition, just like in the case of monopoly, neither allocative efficiency nor productive efficiency are achieved in the short run and long run. And the firm produces with EXCESS CAPACITY (unexploited econs of scale) HOWEVER , product variety could be perceived as beneficial for the society. ALSO firms have incentive to try to produce better or more innovative products (to shift D curve right) or to try to reduce costs with technological innovation

As in the case of monopoly, we can see that P and MB is higher than MC, indicating that there is an underallocation of resources to the production of the good. Society would have been better off if more of the good is produced Also production occurs at a point with AC greater than minimum ATC which symbolizes that some of the scarce resources are wasted and production is not the most efficient

Price and Non-Price Competition Price competition occurs when a firm lowers its price to attract customers away from rival firms thus increasing sales at the expense of other firms Non-Price competition occurs when firms use methods other than price reeducations to attract customers from rivals Most common methods are product differentiation, advertising, branding, quality improvements etc. Firms therefore engage heavily in R&D for product development and methods to create consumer loyalty and favoritism If they are successful, they can attract customers and gain monopoly power by taking control of the price i.e. can charge a high price without losing customers e.g. $200 Nike shoes In other words, the non-price competition methods affects the substitutability of the good, elasticity of the demand, and the monopoly power of the firm If the monopolistically competitive firm can be successful in creating differentiated brand and loyalty through non-price competition, there is less need to rely on price competition

Summary Comparison with Other Market Structures

Comparison of Monopolistic Competition with Perfectly Competitive Markets Similarities: Large number of firms Free entry and exit economic profits or loss in the SR but only normal profits in the LR Differences: Market power (control over price) and downward-sloping demand curve Allocative and productive inefficiency (excess capacity) in SR and LR Product variety Room for economies of scale

Comparison of Monopolistic Competition with Monopoly Similarities: Market power and downward-sloping demand curve Allocative and productive inefficiency in SR and LR Room for economies of scale Firms engaging in R&D and product innovation (non-price competition) Differences: Number of firms Size of firms Lack of barriers to entry and competition Drive prices down in the LR Drive costs down in the LR Normal profits in the LR elastic demand curve