Monopolistic Competition Market Structure

Most markets have neither the single seller required to meet the definition of a pure monopolist nor the large number of small sellers and undifferentiated product necessary to qualify as perfectly competitive.

Monopolistic competition is a market where there are many firms producing similar but differentiated products with each firm having a limited degree of price control. E.g. designers, food industry (colgate ,aquafresh etc.).Monopolistic competition is a form of market in which there are many sellers of a heterogeneous or differentiated product and entry into and exit from the industry are rather eas’;y in the long run. Because of the differences among their products, firms in this market have some control over their price but it is usually small, because the products are close substitutes. The demand curve of a monopolistic competitive firm is highly elastic, but not perfectly elastic as in the case of perfect competition.

Monopolistic competition is most common in the retail and service sectors of an economy. Clothing, hair dressing, detergents and food processing are some of the industries that come close to monopolistic competition at the national level. At local level we can think of fast food outlets, beauty salons all located in close proximity to one another.

Short run price and output determination under monopolistic competition

The figure below shows the price and output determination under monopolistic competition. Since a monopolistically competitive firm produces a differentiated product that has close substitutes, the demand curve it faces is negatively sloped but highly price elastic. As in the case of monopoly, since the demand curve facing a monopolistic competitor is negatively sloped and linear, the corresponding marginal revenue curve is below it. The best level of output of the monopolistically competitive firm in the short run is given by the one at which MR=MC. This is shown by point E1 on figure a. The optimal output is Q1 while optimal price is P1. The monopolistically competitive firm earns an economic profit presented by P1CVA in the figure a below.

Short run and Long Run Price and Output Determination under monopolistic Competition

If firms in a monopolistic competition earn economic profits in the short run, more firms will enter the market in the long run. This shifts the demand curve facing each monopolistic competitor to the left (as its market share decreases) until it becomes tangent to the firm’s LAC curve.  Thus in the long run all monopolistically competitive firms break even (earn normal profit) and produce on the negatively sloped portion of their LAC curve (rather than at the lowest point, as in the case of perfect competition). This is shown in figure b above. The condition to be satisfied for profit maximization in the long run is MR=MC and P=AC.

Product differentiation Refers to a strategy designed to capture and retain particular market segments by producing a range of related products.  The products may be differentiated by packaging, design, content, chemical composition, advertising and other applicable forms. Perfect differentiation leads to a relatively elastic demand. Chamberlin argued that the demand for these products is affected by services associated with the product.

The firm maximizes profit by equating MC with MR hence selling at O P1. The firm makes supernormal profits equal to ABCP1.  The firm then retains or increases these profit levels by engaging in non-price competition e.g. advertisements and repackaging to make its products attractive to buyers.

Long run equilibrium

As long as the firm continues to make supernormal profits, new firms are induced to enter the industry. This leads to a fall in the demand of a single firm’s demand hence shifting the demand curve to the left until the supernormal profits are eliminated. At this point there are no incentives for other firms to enter the market.

Profit maximizing behavior of firms

Firms seek to maximize profits under normal circumstances.

Profits (π) = TR – TC

Conditions for profit maximization 1. Requires that the firms marginal revenue (MR) equal its Marginal cost (MC). MR = MC

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