Monopolistic Competition

Question 1

Explain the characteristics of monopolistic competition:

Answer 1

• Imperfect competition
  
  • Firms are short run profit maximisers
  • Firms sell non-homogenous goods (Product differentiation):
    ◊ A lot of relatively close substitutes
    ◊ Makes XED relatively high between the goods
  • Large number of buyers and sellers
  • Each seller has same amount of market share, but relatively small
  • Firms compete using non-price competition
  • No barriers to entry and exit
  • Firms have some degree of price-setting power as there is a downward sloping demand curve
  • Buyers and sellers have imperfect information

Question 2

Explain with the aid of a diagram short run monopolistic competition; supernormal profit/loss

Answer 2

• In the short run monopolistic competition firms, profit maximise at MC=MR
  
  • Therefore firms make supernormal profit in the short run:
  • Since there are no barriers to entry or exit, new firms enter the market to gain these supernormal profits.

Question 3

Explain with the aid of a diagram long run monopolistic competition; normal profit/loss

Answer 3

• In the long run, with firms having made supernormal profit in the short run, there is an influx of firms in the market to gain from these, since there are no barriers to entry/exit:
  
  • Firms then join due to low barriers of entry
  • Leading to increase in supply
  • Leading to decrease in demand for firms as they all produce on-homogenous goods
  • Leading to AR and MR shifting left
  • Leading to firms producing at new profit max whilst also producing at a normal profit in LR
  • Firms can try to stay in the short run by innovating and differentiating their products

Question 4

Evaluate the Advantages of monopolistic competition

Answer 4

Firms are allocatively inefficient in the Short and Long Run (P>MC)

Wide Variety of Choice for Consumers

More realistic than perfect competition

Supernormal profits in SR will lead to dynamic efficiency in LR

Question 5

Evaluate the Disadvantages of monopolistic competition

Answer 5

In the LR, dynamic efficiency is limited due to normal profits

Firms are not as efficient as those in a perfectly competitive market. In a monopolistically competitive market, firms are x-inefficient as they have no incentive for profits.