Theme 3 Topic 4.3

Question 1

What is monopolistic competition

Answer 1

A market structure in which there are many firms offering a similar product but with some product differentiation e.g nail salons

Question 2

Monopolistic competition features

Answer 2

1. There are a large number of small firms: each one is relatively small and can act independently of the market
2. There are low barriers to entry and exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition
3. The products are slightly differentiated: this structure exists as consumers have different desires e.g. two nail bars can differentiate their product through either an express or pampered service. Some consumers may want a quick service, while others want more attention. A relatively homogenous product has now been differentiated
4. There is a low degree of market power and some price setting ability

Question 3

Profit Maximising Equilibrium in the Short and Long-run

Answer 3

Firms produce where MC = MR.
Because products are differentiated, each firm faces a downward-sloping demand curve.
This gives the firm market power, so it is a price maker.

With some market power and brand differentiation, AR can exceed AC, allowing supernormal profit.

Low barriers to entry mean new firms can enter and imitate existing products.
Entry shifts each firm’s demand curve left, reducing price and market share.
In the new equilibrium, the firm again sets MC = MR, but now AR = AC → normal profit.

Firms try to maintain SR supernormal profit through product differentiation (e.g., a barbershop adds a pool table or complimentary drinks), but this advantage is temporary.

Question 4

Short run profit max

Answer 4

Firms in monopolistic competition are able to make supernormal profit in the short-run
The AR curve is the demand curve of the firm and it is downward sloping
The firm has some market power due to the level of product differentiation that exists
To sell an additional unit of output, the firm will have to decrease its price
The marginal revenue (MR) curve will fall twice as quickly as the AR

Question 5

Short run profit max diagram analysis

Answer 5

The firm produces at the profit maximisation level of output where MC = MR (Q1)
At this level the AR (P1) > AC (C1)
The firm is making supernormal profit = (P - C) x Q

Question 6

Short run losses

Answer 6

Firms in monopolistic competition are able to make losses in the short-run

The firm produces at the profit maximisation level of output where MC = MR (QE)
At this level of output, the AR (PE) < AC (C1)
The firm’s loss is = (P - C) x Q

Question 7

From Supernormal to Normal Profit

Answer 7

If firms in monopolistic competition make supernormal profit in the short-run, new entrants are attracted to the industry and the number of sellers increases
They are incentivised by the opportunity to make supernormal profit
There are low barriers to entry

Supernormal profit will be eroded and the firm will return to the long-run equilibrium position of making normal profit

Question 8

From Losses to Normal Profit

Answer 8

If firms in monopolistic competition make losses in the short-run, some will shut down
The shut down rule will determine which firms shut down
There are low barriers to exit, so it is easy to leave the industry
For the remaining firms, losses will be eliminated and the firm will return to the long-run equilibrium position of making normal profit

Question 9

LR equilibrium

Answer 9

The firm is initially producing at the profit maximisation level of output where MC=MR (Q1)
At this level of output P1 = AC and the firm is making normal profit
In the long-run, firms in monopolistic competition always make normal profit
Firms making a loss leave the industry
Firms making supernormal profit see it slowly eradicated as new firms join the industry

Question 10

Long run efficiencies

Answer 10

No allocative efficiency
No productive efficiency
No dynamic efficiency (however, IF SR supernormal profits are enough to reinvest we could get dynamic efficiency, or there could be small reinvestments in normal profit in long run)