Monopolistic competition: A market structure in which:
o A large number of firms compete. This implies:
Small market share and limited power to influence the price.
Ignoring of other firms because no one firm can dictate the market conditions.
Coordination between firms is difficult, and collusion is impossible.
o Each firm produces a differentiated product, one that is a close substitute, but not a perfect substitute
for other firms’ products.
o Firms compete on product quality, price, and marketing.
Quality: The physical attributes that make a product different (design, reliability, service).
Price: The demand curve is downward sloping, so there is trade-off between price & quantity
Marketing: Appropriate advertising and packaging for the target market group.
o Firms are free to enter and exit the industry.
In the long run, firms in monopolistic competition:
Make no economic profit.
Neither enters nor leaves the industry.
When existing firms make a profit, new firms enter the industry and lower the price.
When existing firms make a loss, some firms leave the industry and increase the price.
Price and Output in Monopolistic Competition
o A firm in monopolistic competition makes its output and price decision just as a monopoly firm would.
o A firm’s goal is to maximize economic profit, so
Output: A point where Marginal cost = Marginal revenue
Economic Profit / Loss: (Demand – ATC) x Output
o If demand > ATC, the profit maximization point is a profit.
o If demand < ATC, the profit maximization point is a loss.
o If demand = ATC, the profit maximization point is 0.
o Demand equals ATC, and therefore there is zero economic profit.
o If economic profit is not zero, firms will enter or exit until it becomes zero.
Comparison with perfect competition:
o In perfect competition, demand = marginal revenue = minimum ATC
o In monopolisti