Monopolistic Competition

Why Most Markets Aren't Perfect

Think about all the shampoo choices at stores like Target or Kroger - there are loads, and they're each a little different in smell, packaging or the 'magic' they promise. None of those companies completely controls the market (they aren't a monopoly), and none have a perfectly competitive situation. They all sell shampoo, but each one has managed to get a little bit of power because of how they've made their product seem special.

Monopolistic competition brings together things that seem to go against each other: each company has a mini-monopoly on their particular brand, but it's really easy for new companies to start up, so any advantage they have doesn't last.

Four things define this kind of market. Lots of companies, and each one is too small to affect the price of everything. The products are different from each other, though they're similar and can be used instead of each other. Businesses can start and stop doing business as they choose. And each business faces a demand curve that goes downwards - because their product is at least a bit different from everyone else's.

Look at the demand curve on the graph. It does slope down, but it's quite flat. That flatness is really important. Starbucks can get away with charging more than a simple diner because people think it's different and a better brand. However, if Starbucks suddenly raised the price of a latte to $12, most people would go to the coffee shop over the road. Similar options mean the demand curve doesn't become very steep.

Short-Run Profit Maximization

For short-run maximizing of profit, switch the graph to "Short Run" and look at the shaded rectangle. That shows economic profit.

In the short term, a business in monopolistic competition behaves very much like a typical monopoly. A demand curve that goes downwards. A marginal revenue curve under the demand curve - for the same mathematical reason as with a monopoly: if you lower your price to sell just one more item, you also lower the price of all the ones you've already sold.

The business makes the most profit where Marginal Revenue equals Marginal Cost (MR = MC), and then looks 'up' to the demand curve to see what customers will actually pay for that amount. If that price is above the average total cost, the business makes a true economic profit. The shaded rectangle between the price and average total cost at the amount where profit is highest (move your mouse over it) represents profit over and above what the owners could get from doing anything else.

Here's an example. A fancy bakery has a demand of P = 90 - 0.8Q, which means MR = 90 - 1.6Q. The cost to make each additional item (marginal cost) is MC = 10 + 0.5Q. To find when MR = MC, we do: 90 - 1.6Q = 10 + 0.5Q, which simplifies to 80 = 2.1Q, and Q = approximately 38 items. The price would be: P = 90 - 0.8(38) = $59.60. If the average total cost at 38 items is $42, the profit would be ($59.60 - $42) x 38 = roughly $669.

Long-Run Adjustment: Profit Gets Competed Away

Now, for the long-run adjustment and how profits disappear, switch the graph to "Long Run" and watch the profit rectangle. It's gone!

Those short-run profits brought in new companies. Another bakery opened on the same street, then another after that. Each new competitor took customers from the existing businesses, which meant the demand curve for each of the original companies moved to the left. New companies keep entering the market as long as there's any economic profit to be made. This only stops when the demand curve of each company has moved so far left it just touches the average total cost curve.

At this point where they touch (look closely at the graph), the price is exactly the same as the average total cost. No economic profit.

When a market is in long-run equilibrium with monopolistic competition, three things happen at the same time: P = ATC (no economic profit), MR = MC (companies are still maximizing profit) and the demand curve only touches the ATC curve at a single point - it doesn't go into it, it's tangent to it.

If companies are losing money, the opposite happens. When some companies leave the market, the demand for the ones that are left goes up, and things continue to adjust until profits get back to nothing. The market finds that point where the curves just touch, much like a swinging pendulum eventually comes to rest.

Excess Capacity and the Markup

On the long-run graph, look at where the company is on the average total cost (ATC) curve; it's on the part that slopes downwards, and is to the left of the lowest cost point. The distance between what it's actually producing and the amount at that lowest cost is the excess capacity. The company could reduce its average costs by making more, but if it did, it would have to lower prices below ATC and lose money. Think about restaurants, hair salons, and small clothing stores; they usually aren't very full. That restaurant which is half empty on a Tuesday afternoon? That's a visible example of excess capacity.

Now, compare the price to the marginal cost (MC) curve. The price is higher than the marginal cost. This difference is the markup over marginal cost. In perfect competition, price and marginal cost are the same. Here, price is higher than marginal cost because the sloping demand curve creates a difference between the two. Customers pay a little more for each item, but they get a choice of different options: Thai, Italian, Ethiopian, all on the same street!

Is this excess capacity a waste? Some economists believe so, stating that resources are too spread out across too many companies that aren't making at their best possible size. Others say the variety customers receive is worth a little bit of inefficiency. For the AP exam, you're expected to show you know excess capacity is part of how this model works, without saying whether it's good or bad. Just point to the graph, say where on the ATC curve the company is, and describe the difference.

Monopolistic Competition vs. Other Structures

Where does monopolistic competition fit in with other market types? At one end is perfect competition, with lots of companies, the same product, price equals marginal cost, no profit, and no excess capacity. At the other end is a monopoly, with one company, a unique product, price higher than marginal cost, continuing profit, and reduced production.

Monopolistic competition is much closer to perfect competition. Like perfect competition, it has many companies and it's easy for new ones to start up, which pushes profits to zero over time. But like a monopoly, each company faces a downward sloping demand curve and charges a price higher than marginal cost. Switch between the different market structures on the graph and look at the size of the deadweight loss triangles. Monopolistic competition's triangle is significantly smaller than the monopoly's.

How is monopolistic competition different from perfect competition? Companies have some control over price because their products are different (instead of just accepting the price) price is above marginal cost causing a small deadweight loss, and companies produce below the point where costs are lowest (so they have excess capacity). However, like perfect competition, there is no economic profit in the long run.

And how is it different from a monopoly? New companies entering the market eliminate long-term economic profit, lots of similar choices mean demand is fairly sensitive to price changes (look at the flatter demand curve), and the markup and the deadweight loss are a lot smaller.

On the AP exam, certain wording will be a clue. "Differentiated products" and "free entry" mean monopolistic competition. "Identical products" mean perfect competition. "Barriers to entry" mean monopoly or oligopoly.

What Students Get Wrong

Students often make mistakes in these areas. Both monopolistic competition and perfect competition end up with zero economic profit in the long run. Often an incorrect answer on an AP question comes from getting confused about how each market structure gets to that point. In perfect competition, price equals marginal cost which equals minimum average total cost. In monopolistic competition, price equals average total cost but is higher than marginal cost, and the company isn't at the lowest point on the average total cost curve. They have the same profit, but the graphs look completely different.

Zero economic profit doesn't mean the company is doing badly. It means the company is getting a standard rate of return, enough to stay in business and enough for the owners to make what they would in their next best job. The company is doing okay; it's just not making anything extra on top of what it should reasonably expect.

People often incorrectly say that demand becomes flat (horizontal) over the long term. That's not true. If you look at the long-run graph, you'll see the demand curve has moved to the left, meaning there are fewer customers for each company now that more companies are in the market. However, it still slopes downwards; the product is still different from anything else. If demand were horizontal, you'd have perfect competition and no excess capacity.

Another point to remember: in the long run, the demand curve is tangent to Average Total Cost (ATC), not Marginal Cost (MC). It barely touches ATC from above. If the quantity was any different, Average Total Cost would be higher than the price, and that would prove zero profit is all this company can achieve.