Monopolistic competition takes its name because of the fact that it combines the many buyers and sellers of perfect competition with the greater flexibility in pricing observed in monopoly. As a result the firm is likely to produce less as a result of each firm representing a small proportion of the market and sell at a higher price than under perfect competition which has made many economists consider monopolistic competition as an inefficient market structure. Monopolistic competition, apart from the large amount of buyers and sellers is also characterised by product differentiation which is what gives producers the flexibility to have price setting behaviour to a small extent. This is why firms under monopolistic competition face a downward sloping demand curve. Finally under monopolistic competition there are limited opportunities for economies of scale due to the small size of the firms and there are no barriers to entry and exit.
In the short run firms in monopolistic competition may face abnormal profits or losses. The following diagram illustrates the case for firms facing positive economic profits.
In the above diagram we see the downward sloping demand curve which is faced by a representative firm and occurs because not all units are priced the same as under perfect competition where price is equal to average revenue. The reason why there is this difference in price is because product variation enables producers to compete on the basis of whether or not their product generates extra utility for their consumers as opposed to having to compete on the basis of price as is the case for perfect competition. The firm, being profit maximising, produces where marginal cost equals to marginal revenue and charges the profit maximising price P1. As a result, it earns abnormal profits equal to the green shaded area. The difference between this diagram and the diagram for monopoly in the short run is that in monopolistic competition, we have many firms in the market which means there is a certain degree of interdependency which doesn’t exist under monopoly.
Since there are no barriers to entry under monopolistic competition in the long run the abnormal profits earned will work as a signal for other firms to join the market which is what leads us to the long run equilibrium seen in monopolistic competition. The reason why firms enter and exit in the long run is because all factors are variable and thus firms have the ability to obtain these factors or sell the ones they have because in the long run they are no longer fixed. The more firms enter the market the greater product differentiation will occur implying that the firm already existing in the market will lose due to the greater choice consumers will have gained seeing that this choice implies they will have greater substitution possibilities. As a result each individual firm represents a smaller percentage of the total industry’s output and its demand curve shifts inwards causing both price and quantity produced to reduce leading to lower profits for the individual firm in the market. However, as long as there are profits made firms will continue to enter the market until they are competed away. In other words, this procedure will continue until the average cost curve is tangent to the demand curve. This is because at that point average revenue equals average cost and firms are earning only normal profits. After normal profits are earned in the industry there is no incentive for new firms to join and the industry reaches its long run equilibrium. These normal profits are illustrated in the following diagram.
p>Again we see that as firms enter the market the demand curve keeps shifting inwards until its tangent to the average cost curve. The firms attempting to profit maximise will price where marginal cost equals to marginal revenue so they produce the lower output X2 and price at the lower price P2. It is important to point out that even though normal profits are made, the firm isn’t minimising costs. This is because due to the product differentiation the firm will have to construct a plant smaller than the minimum cost size of a plant and operate it at less than the minimum cost rate of output. As a result normal profits will be obtained at diminishing marginal costs, so even though normal profits are earned the firm could further reduce costs by increasing output. This however, wouldn’t lead to maximisation in profit because the extra output produced as a way of reducing costs won’t be sold so even though costs will be lower revenue earned from these last units won’t cover these costs. Graphically, the reason why the firm can’t cost-minimise is because the demand curve is downward sloping so the long run average cost must also be downward sloping at the long run equilibrium output rate. This is why economists argue that monopolistic competition is problematic due to excess capacity as there is usually overcrowding of monopolistically competitive markets which leads to many small firms having access to the market and producing small percentages of total output at relatively high costs because they don’t take advantage of their diminishing marginal costs.
The only way we can determine whether or not this apparent inefficiency is as problematic as economists used to think is by comparing the above model to perfect competition. The only reason why perfect competition has lower costs is due to the fact that it has a flat demand curve and the reason why this happens is due to one of the key assumptions that exists under perfect competition and not under monopolistic competition and that is product homogeneity. This product homogeneity forces firms to price all products the same because they can only compete on the basis of price. Charging higher than the market price is impossible and charging lower would mean they are making losses, thus in perfect competition, average revenue is constant and equal to price. This means that firms under perfect competition will be able to produce higher outputs and take advantage of their diminishing marginal costs to the point where they minimise costs. However, even though perfect competition has the ability to minimise cost s in the long run it does so at the expense of product variation. As a result it would be incorrect to say that the excess capacity observed under monopolistic competition is a sign of inefficiency because the utility we gain from product variety can’t be measured. In other words we can’t say whether we gained or lost by the trade off between lower costs and variety because our gain in utility generated by the greater variety observed under monopolistic competition can’t be measured. So essentially the only conclusion we can make is that variety is costly.
Overall we see that the many buyers and sellers observed in perfect competition and monopolistic competition lead to the long run equilibria in both industries presenting normal profits. However, the normal profits for perfect competition are at the minimum point of its average total cost curve whereas in monopolistic competition they are at the point of diminishing marginal costs thus reflecting excess capacity. Even though his excess capacity could be considered a sign of inefficiency it is important to understand that it reflects a trade-off between lower costs and greater choice and thus we can’t make such an assessment with absolute certainty.