Monopolistic Competition
What is Monopolistic Competition?
Monopolistic competition is a market structure with many firms selling differentiated products and facing low barriers to entry.
Firms in monopolistic competition have some pricing power due to product differentiation but face competition from many rivals. In the long run, they earn zero economic profit as new firms enter when profits are positive.
Monopolistic Competition: a worked example
A neighborhood gym differentiates itself on location and class schedule, charges $40 a month, and serves 300 members where marginal revenue equals marginal cost. With average total cost of $34 at that membership level, economic profit is ($40 - $34) x 300 = $1,800 a month. Those profits attract new gyms, which pull members away and make the existing gym's demand curve both lower and flatter, until the gym's new marginal revenue equals marginal cost at 220 members, it charges $36, and average total cost has risen to $36 as well. Economic profit is then zero and entry stops, which is the long-run equilibrium of monopolistic competition.
The mistake students make with monopolistic competition
Students see zero long-run economic profit and conclude that monopolistically competitive firms end up efficient like perfectly competitive ones. Zero profit here comes from the downward-sloping demand curve being tangent to average total cost, and that tangency happens on the falling portion of the ATC curve, to the left of its minimum. The firm therefore produces less than the output that minimizes average cost, leaving excess capacity, and it still charges a price above marginal cost, so it is neither productively nor allocatively efficient.
Monopolistic Competition questions
What is the difference between monopolistic competition and perfect competition?
Monopolistic competition has differentiated products, which gives each firm a downward-sloping demand curve and the power to set price above marginal cost, while perfect competition has identical products and firms that must take the market price. Both have easy entry and exit and both earn zero economic profit in the long run.
What are examples of monopolistic competition?
Restaurants, hair salons, coffee shops and clothing brands are the standard examples of monopolistic competition, because each market has many sellers, entry costs are low, and every firm differentiates itself by quality, style, branding or location. That differentiation gives each one a little pricing power without protecting it from new rivals.
Why do monopolistically competitive firms earn zero economic profit in the long run?
Monopolistically competitive firms earn zero economic profit in the long run because entry is easy, so positive profits draw in new differentiated rivals who take away part of each existing firm's demand until price only just covers average total cost. If firms are making losses instead, some exit, demand for the survivors rises, and profit returns to zero from the other direction.
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