Monopolistic competition

Question 1

Monopolistic competition

Answer 1

a market that shares some characteristics of monopoly and some of perfect competition

Question 2

Product differentiation

Answer 2

a strategy firms adopt that marks their product as being different from their competitors’

Question 3

5 Characteristics of monopolistic competition

Answer 3

1. A large number of firms
2. No dominant firm
3. No (or low) barriers to entry
4. Product differentiation
5. Downward-sloping demand curve

Question 4

Why are there a large number of firms in monopolistic competition

Answer 4

A price change by one firm will have negligible effects on demand for rivals’ products because market share of each firm is low

Question 5

Why is there no dominant firm in monopolistic competition

Answer 5

No firm has significantly more power than others

Question 6

Why is there no (or low) barriers to entry

Answer 6

So if incumbent firms are making SNP, new entrants will be attracted and try to make their product slightly different (product differentiation)

Question 7

Why is there product differentiation in monopolistic competition

Answer 7

1. Firms’ products are slightly different to competitors’ in some way
2. Consumers perceive non-price differences among products leading to brand loyalty
3. Firms advertise to maintain brand loyalty
4. Products in the market are fairly close substitutes
5. So demand is usually relatively price elastic (and more elastic the smaller the differences between products – and the better substitutes they are)
   Downward-sloping demand curve

Question 8

Why is there a downward sloping demand curve in monopolistic competition

Answer 8

A reduction in price would increase quantity demanded, so firms have some control over price. This is due to the price making power afforded by product differentiation

Question 9

Examples of monopolistic competition

Answer 9

restaurants
coffee shops
pubs
hotels

Question 10

Analysis monopolistic competition short run

Answer 10

shows monopolistic competition in the short run. Firms are assumed to profit maximise, so produce at MC=MR leading to output Q0 at a unit cost of AC0 and price P0. P0-AC0 is the supernormal profit per unit, so the shaded rectangle Q0x(P0-AC0) is the total SNP. Due to low barriers to entry, this SNP will attract new firms which will produce differentiated products; so this supernormal profit can only be earned in the short run.

Question 11

Analysis monopolistic competition long run

Answer 11

shows monopolistic competition in the long run. Firms were attracted by the supernormal profits made by incumbent firms and were able to enter the market due to low barriers to entry. These new entrants cause established firms’ demand curves to shift to the left as market demand is split between more firms. Incumbent firms respond to increased competition by increasing their spending on advertising, raising the average cost at all levels of output, shifting up the AC curve. The combined impact is that competition in the long run competes away all the supernormal profit, leaving only normal profit and there is no further incentive for more firms to enter the market.

Question 12

Advantages of monopolistic competition

Answer 12

1. Competition lowers prices and increases choice for consumers

In the long run new entrants competing drives down prices for consumers because lower barriers make market entry possible. It also increases choice, increasing utility as consumers buy the product that best reflects their preferences

2. Lower X-inefficiency

Competition disciplines firms leading to less X-inefficiency than under a more complacent monopolist

3. Advertising informs consumers

High level of advertising ensures consumers are informed about products available

Question 13

Disadvantages of monopolistic competition

Answer 13

1. No economic efficiency

Not productively efficient because not producing where AC=MC (bottom of AC curve), and AR (price) does not equal MC so not allocatively efficient either in either the short run or the long run

2. Advertising spending is wasteful

To get and maintain brand loyalty, firms advertise heavily, increasing average cost. The SNP spent on advertising would be better used on investing in the factors of production to improve the quality of products, as this would increase consumer utility

3. Unable to fully exploit economies of scale
   The ease of entry, and number of firms, means that the typical firm is unlikely to be fully exploiting the economies of scale that are possible leading to higher prices for consumers than could otherwise be achieved

Question 14

Judgement of monopolistic competition

Answer 14

The assumptions underpinning monopolistic competition may be unrealistic and not reflect market conditions in the real world.

The extent to which monopolistic competition is beneficial depends on the characteristics of the product, as this determines the extent to which the opportunities for economies of scale have been achieved or foregone.