Monopolistic Competition

Unit 7 - Lesson 9
Learning outcomes:
● Define the terms in orange bold in the text (AO1)
● Explain that monopolistic competition has less market power due to many
substitutes compared to monopoly and illustrate with a diagram showing
more elastic demand curve than monopoly (AO2, AO4)
● Explain profit maximisation in the short-run and long-run, with diagrams
showing abnormal profit, normal profit and loss (AO2, AO4)
● Explain allocative inefficiency and market failure in monopolistic competition
(AO2).
● Explain that monopolistic competition has more product variety in exchange
for less efficiency (AO2)
● Discuss the advantage and disadvantages of monopolistic competition (A03)
Assumed Characteristics of Monopolistic Competition
Monopolistic Competition is based on the following assumptions:
● Large number of firms
● There are no or very limited barriers to entry and exit to the market
● The products can be differentiated
○ Physical Differences - products may differ in size, shape, material, texture,
taste packaging etc.
○ Quality Differences - products can differ in quality
○ Location - physical or virtual
○ Services - some firms offer specific services to attract and maintain
customers
○ Product Image - celebrity advertising, endorsements or attractive packaging
Watch the video - What product is being advertised? How are they trying to
differentiate their product?
Product Differentiation and the Demand Curve

As the term suggests, “Monopolistic Competition” has elements of both Perfect

Competition and Monopoly.

● Perfect Competition: many firms in the industry and there are no or limited
barriers to entry or exit.
● Monopoly: Product differentiation

In Monopolistic Competition if a firm raises its price it will lose more sales than
the Monopolistic firm because consumers have substitutes they can switch to.

The substitutes in Monopolistic Competition are not perfect substitutes like

Perfect Competition.
Demand Curve for Monopolistic Competition

Therefore the Demand curve for a Monopolistically Competitive firm:

● Demand in Monopolistic Competition is more elastic than perfect competition

● Demand in Monopolistic Competition is less elastic than Monopoly
Role of Price and Non-Price Competition
Price Competition:

● Occurs when firms lowers 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 reductions to attract customers.
○ The most common form of non price competition is product differentiation.
■ Monopolistically Competitive firms invest heavily in Research and
Development to differentiate products.

Monopolistically Competitive firms compete with each other using both price and
non-price competition in order to try and increase their market share.
Profit Maximisation - Monopolistic Competition
For the same reasons as previously
discussed a profit maximising
Monopolistically Competitive firm will
produce:
● Marginal Cost (MC) is equal to Marginal
Revenue (MR)
● Where MC = MR is the monopolistic
competitive profit maximising quantity
of output (Qpm)
● At (Qpm) the Monopolistically
Competitive firm will charge a price of
(Ppm)
Monopolistic Competition in the Short-run to Long-run
Monopolistic Competitive firms can make the following in the short-run:
● Abnormal Profit
○ Price (P) is greater than Average Total Cost (ATC)
● Normal Profit
○ Price (P) is equal to Average Total Cost (ATC)
● Loss
○ Price (P) is less than Average Total Cost (ATC)
In the long-run similar to Perfect Competition, Monopolistic Firms:
● Will always make Normal (Zero economic) Profit
○ Price (P) is equal to Average Total Cost (ATC)
The reason for this is the assumption that there are no or little barriers to entry
or exit into the market. Similar to Perfect Competition.
Monopolistic Competition - Abnormal Profit
Abnormal Profit occurs when:
● Abnormal Profit = Total Revenue is
greater than Total Cost
○ Total Revenue (TR) = Price (P)
times Quantity (Qpm)
■ It is the sum of the area of A + B
○ Total Cost (TC) is equal to the area
of B
■ To find TC draw a line from Qpm
to ATC and then over to the
price axis.
● Total Revenue (A + B) is greater than
Total Cost (B) therefore the firm is making
an Abnormal Profit of the area of A.
Monopolistic Competition - Normal Profit
Normal Profit occurs when:
● Normal Profit = Total Revenue is equal to
Total Cost
○ Total Revenue (TR) = Price (P)
times Quantity (Qpm)
■ It is the sum of the area of A
○ Total Cost (TC) is equal to the area
of A
■ To find TC draw a line from
Qpm to ATC and then over to
the price axis.
● Total Revenue (A) is equal to Total Cost
(A) therefore the firm is making an
Normal Profit of the area of A.
Monopolistic Competition - Economic Loss
Economic Loss occurs when:

● Economic Loss = Total Revenue is less than

Total Cost
○ Total Revenue (TR) = Price (Ppm) times
Quantity (Qpm)
■ It is the sum of the area of B
○ Total Cost (TC) is equal to the area of A
+B
■ To find TC draw a line from Qpm to
ATC and then over to the price axis.
● Total Revenue (B) is less than Total Cost (B)
therefore the firm is making an Normal Profit
of the area of A.
Monopolistic Competition - Long-run
In Monopolistic Competition, in the
long-run, profit making firms attract new
entrants into the market due to the
assumption of no or little barriers to entry.

Some loss making firms in the industry

will shut-down and exit the market.

The process of entry and exit of firms in

the industry in the long-run ensures that
economic profit and loss is zero and all
firms make normal (zero) economic
profit.
Criticisms of the Model
Criticisms of the Model of Monopolistic Competition

1. Model suggest that firms make decisions only on quantity of output and price.
However, a major aspect of their decision making involves non-price
competition. Therefore profit maximization decisions are much more complex
than this model suggests.
2. In the real world the barriers to entry can be greater than is assumed with this
model.
3. Another difficulty is that in view of product differentiation, it is not possible to
derive an “industry” demand curve, as each product is different from the
others therefore we can only view monopolistic competition at the level of the
“firm” and not the “industry”.
Explain the monopolistic competitive inefficiency illustrating market failure (AO2)

Market failure occurs when the market is not

allocatively efficient - consumer and producer
surplus are not maximized resulting in a total
welfare loss (TWL).
Consumer surplus: benefit enjoyed by the
consumer for paying a price lower than what they
were willing to pay. Located above the price and
below the demand curve.
Producer surplus: benefit enjoyed by the
producer for receiving a price higher than what
they were willing to sell the good for. Located
below the price and above the supply=MC.
Explain the monopolistic competitive inefficiency illustrating market failure (AO2)

A monopolistic competition charges a higher

price (Ppm vs. Pae) and lower quantity (Qpm
vs. Qae) than what is socially optimal.
Allocatively Monopolist Increase/
Efficient Decrease

Consumer
Surplus a+b+c a Decrease

Producer
Surplus d+e b+d Increases

Total Welfare
Loss N/A c+e Increases
Explain that a monopolist is productively inefficient.
Graph on the right is a monopolistic
competitive making zero economic
profit:
○ Monopolistic competitive market
structures are not productively
efficient since price (P) does not
equal minimum ATC.
○ P is greater than minimum ATC
A monopolistic market structure is
never allocatively or productively
efficient.