3.4.3 Monopolistic Competition

Question 1

Monopolistic competition

Answer 1

• a large number of small firms produces non-homogenous products
• there are no barriers to entry or exit
• an inelastic demand curve (can set prices)
• However, freedom of entry = supernormal profits = firms to enter the market leading to normal profits in the long term.

Question 2

Features of monopolistic market

Answer 2

• Freedom of entry and exit.
• Firms produce differentiated products.
• Firms have price inelastic demand (are price makers since the good is highly differentiated)
• Firms make normal profits in the long run but could make supernormal profits in the short term
• Firms are allocatively and productively inefficient.

Question 3

Assumptions for monopolistic competition

Answer 3

• there are a large number of small firms (many producers)
• there are low barriers to entry and exit
• firms produce similar but differentiated products
• profits are maximised

Question 4

Product differentiation graph

Answer 4

• there’s a downward sloping curve bc firms have some market power. They can change price and will not lose all customers
• the firm will profit maximise & produce where MC=MR so will produce at an output level of Q1 and charge price P1

Question 5

Monopolistic competition in the long run graph

Answer 5

In the long run, supernormal profits will be eroded because new firms will enter the market owing to lack of barriers to entry. The entry of new firms will increase supply, shifting the average revenue curve downwards to the point where AR=AC, as in the diagram. If the firm was making a loss, it would leave the industry, reducing supply and shifting the AR curve upwards again to a point where AR=AC. Therefore, in the long run, a monopolistically competitive firm can make neither supernormal profits nor losses

Question 6

Monopolistic competition in the short run graph

Answer 6

In the short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to supernormal profit

Question 7

Monopolistic competition (differentiated products)

Answer 7

Each producer has a product that consumers view as somewhat distinct from the products of competing firms but at the samet I’ve are considered closer substitutes

Question 8

Monopolistic competition (free of entry and exit)

Answer 8

• New producers with their own distinct products can enter the industry freely in the long run
• And firms will exit the industry fit they find they are not covering their costs in the long run
  Short run = profits max (supernormal profit) - MR = MC
  Long run = just normal profits price = ATC

Question 9

Short run graph

Question 10

Long run graph

Answer 10

D & MR flattens and moves in as firms enter
- because there is free entry, in the long run, firms in monopolistic competition cannot sustain economic profit

Question 11

Perfect contestability assumptions

Answer 11

1. No or low barriers to entry or exit
2. No sunk costs in particular
3. Similar products with high and positive cross elasticities
4. Perfect knowledge

Question 12

Monopolistic competition vs perfect competition

Answer 12

• In the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit (normal profit).
• Price exceeds marginal cost.

Question 13

Is monopolistic competition allocative inefficient?

Answer 13

• A monopolistic competitor charges P>MC, still allocative inefficient
  • but “Closer” to allocative efficiency than monopoly since there’s Incentive for advertisement

Question 14

Is monopolistic competition productive inefficient?

Answer 14

• productive inefficiency (not able to exploit econ of scale fully) of every monopolistic competitor implies another source of inefficiency of wasteful duplication
  i.e. monopolistically competitive industries offer too many varieties

Question 15

Example of monopolistic market

Answer 15

Hair salons