A monopolistic competitive market structure is usually a more realistic market structure than perfect competition.
What are its properties? Is it a desirable or undesirable market structure?
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Contents
Basic properties of monopolistically competitive markets
A monopolistically competitive market has the following properties:
- A large number of small firms
- Low barriers to entry
- Products are similar but differentiated. This is the key difference between perfect competition and monopolistic competition.
- Price makers / setters
- Demand is relatively elastic. This is because of a high number of substitutes.
Examples of monopolistically competitive markets
- Hairdressers
- Restaurants to some degree
- Coffee shops
Diagrams
Short run
We have the usual average cost and marginal cost curves.
Revenue curves are downward-sloping. As products are differentiated, firms are price setters.
However because there are many substitutes, the revenue curves will be more elastic compared to monopoly revenue curves.
So in the short run, the diagram is similar to a monopoly. But with more elastic average revenue and marginal revenue.
For more notes on monopoly, see the blue button below:
Here a firm can make supernormal profits in the short run. The area that represents supernormal profits is:
$$(p-c)q$$
Long run
Low barriers to entry means firms can enter the market in the long run.
Observing supernormal profits in the short run, firms may enter to grab a slice of these profits.
This reduces the market share of each firm, reducing the individual demand that the firm faces.
This means in the long run, AR and MR shift left until there is zero supernormal profit.
This means that in the long run, AR=ATC (zero supernormal profit).
Note when drawing the long run diagram, MR=MC at the same output level where AR=ATC.
Make sure you get this right when drawing – I recommend drawing the cost curves first, then each revenue curve.
Efficiencies
First, there is dynamic inefficiency in the long run . One could argue there is dynamic efficiency in terms of short run profits.
Also we have productive inefficiency – generally the firm does not produce at the minimum point of its ATC,
Monopolistically competitive markets are also allocatively inefficient – price (or average revenue) does not equal marginal cost.
Other qualities of monopolistic competition
- Keeps prices low compared to monopoly. Increases consumer surplus and welfare.
- Reduced firm profits. Greater risk of firm failure.
- Cannot realise economies of scale but may prevent diseconomies of scale.
- Variety is good for consumers, increasing consumer welfare.
- Firms invest in product differentiation. This could include add-on services, targeting a particular niche, loyalty bonuses etc. Some argue this may mean an over investment in for example advertising. Too much advertising could also overwhelm or mislead consumers. This could create an imperfect information market failure. This could then represent a market failure.
Other evaluation points
The success or desirability of monopolistic competition depends on:
- The extent of advertising. It is difficult to assess the “socially optimal” level of advertising. Indeed some level of advertising can be informative to consumers, while providing jobs in media.
- The extent of barriers to entry. If there is a lot of advertising, this may itself be a barrier to entry. Barriers to entry are more likely to exist in real markets E.g .brand loyalty or economies of scale.
- Short run versus long run – short run supernormal profits are possible. This allows firms to reinvest the profits e.g. in R&D.
- The objectives of the business may influence outcomes at least in the short run. The analysis above assumed the firm maximised profits. Yet the firm could instead be maximising sales for example.
For more on business objectives, click the blue button below:
Academics on monopolistic competition
Chamberlain and Robinson came up with the theory of monopolistic competition. However the Dixit-Stiglitz model of monopolistic competition in the 1970s helped push the theory into other areas of economics.
It has come to be used in multiple areas. For example monopolistic competition is used in trade theory. Paul Krugman used this idea to explain intra-industry trade across countries (which the theory of comparative advantage does not explain).
Macroeconomic models have also drawn on monopolistic competition. Monopolistic competition may be a more realistic view of how firms behave compared to perfect competition. Hence monopolistic competition may generate more accurate insights about how the economy works.
Some economists have even termed the move towards monopolistic competition models a “revolution” in economic theory (Brakman and Heijdra).
You can also see monopolistic competition being used in urban economics (the formation of cities) and many other subfields of economics.
Related questions
What is the difference between monopolistic competition and monopoly?
Monopolies are likely to have higher barriers to entry, fewer and larger firms, as well as fewer substitutes.
What is the difference between monopolistic competition and perfect competition?
In perfect competition goods are homogenous. In monopolistic competition goods are differentiable even if they are similar. This gives firms some price making power in monopolistic competition.
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