Monopolistic competition

Question 1

What are the characteristics of monopolistic competition

Answer 1

1. Many buyers and sellers
2. Slightly differentiated goods so firms are price makers but only limited price making ability
3. Low barriers to entry/exit
4. Good information of market conditions
5. Lots of non-price competition e.g. branding, advertising, quality
6. Firms are profit maximisers

Question 2

Why do firms in monopolistic competition have price elastic demand curves

Answer 2

• They have slightly differentiated goods but consumers can still move to close substitutes easily, reflecting the limited price making ability that firms have
• Think of it as in between a monopoly’s demand curve and perfect competition firm demand curve

Question 3

Why do firms need to rely on non-price competition to get ahead of rivals

Answer 3

• Firms can’t change prices significantly compared to market rate due to high PED demand
• Therefore, they rely on non-price factors to compete

Question 4

Why is the monopolistic competition diagram in the short run very similar to monopoly

Answer 4

Firms are price makers and profit maximisers so same as monopoly but with slightly more elastic AR curve

Question 5

Why do firms in monopolistic competition make normal profit in the long run

Answer 5

• New firms are incentivised to enter market due to supernormal profits in the short run and can enter as barriers to entry are low and there is good information in market
• Same number of consumers shared across more firms means demand for individual firm shifts left until normal profit is made and there is no more incentive for new firms to enter market

Question 6

What is the easiest way to draw the long run monopolistic competition diagram

Answer 6

• First draw AR and then MR 2x steep as normal
• Next draw MC curve
• Then mark on profit max price P1 and quantity Q2
• Now draw AC curve which is shifted upwards so that it touches AR at P1 Q1 and MC passes through minimum point

Question 7

Is there allocative efficiency in monopolistic competition in the long run

Answer 7

• No as price is greater than MC
• Therefore, prices too high and quantity too low so less consumer surplus, choice, quality

Question 8

Is there productive efficiency in monopolistic competition in the long run

Answer 8

• No as not operating on minimum point of AC curve
• Causes higher prices for consumers

Question 9

Is there dynamic efficiency in monopolistic competition in the long run

Answer 9

• No as normal profit is made in the long run so not enough supernormal profit to invest back into the company

Question 10

Why might the level of allocative efficiency actually be good for consumers in monopolistic competition

Answer 10

• Elastic demand curve compared to monopoly as firms have less price making ability so consumers are not being exploited much compared to monopolies so far more allocatively efficient than monopolies
• Consumers may not want homogenous goods like in perfect competition, e.g. in industries like clothing, restaurants etc
  So consumers may be willing to erode a bit of CS and pay slightly more for differentiated goods

Question 11

Why might the level of productive efficiency actually be good for consumers in monopolistic competition

Answer 11

• Lots of substitutes so firms can’t afford to not exploit economies of scale compared to monopolies so monopolistic competition is far more productively efficient than monopolies, who are complacent
• In perfect competition, firms are so small that their PE point may be higher price and lower quantity than slightly productively inefficient monopolistic competition firms i.e. MC curve is shifted down
• Also, it is harder to be productively efficient for firms selling differentiated goods as they can’t bulk buy so maybe the slightly higher price is the cost of wanting differentiated goods

Question 12

Why might there still be dynamic efficiency in monopolistic competition

Answer 12

• Short run supernormal profits may still be enough to invest but on a smaller scale
• The firm may have to reinvest as it is part of competition in the market even at normal profit e.g. clothing businesses who have to create new fashion lines constantly so they don’t fall behind

Question 13

Why might there be more dynamic efficiency in monopolistic comp than both perfect competition and monopolies

Answer 13

• In perfect competition, there is much smaller profits and reinvestment less likely to be part of competition in the market
• Monopolies may use their supernormal profits elsewhere (e.g. dividends) as they don’t have an incentive to use them to compete against other firms