IB Economics 2.11.8 Monopolistic Competition Notes

Monopolistic Competition: Many Firms, a Little Power

1. Monopolistic competition sits between perfect competition and monopoly.
2. Many firms compete and barriers to entry are low, but each sells a slightly differentiated product, a different brand, recipe, location, or style.
3. That differentiation gives every firm a sliver of market power, so its demand curve slopes down rather than being flat.

The Short Run: Profit or Loss, Just Like a Monopoly

1. In the short run the firm behaves like a monopoly.
2. Because its demand curve slopes down, marginal revenue lies below price, so it maximises profit where $MR = MC$, then reads the price up to the demand curve.
3. If that price is above average total cost, the firm earns abnormal profit, the shaded rectangle on the left.
   1. If the price is below $ATC$, it makes a loss instead, the shaded rectangle on the right.

The Long Run: Entry, Normal Profit, and Excess Capacity

1. The real difference from monopoly is what happens next, driven by free entry and exit.
2. Short-run profit is a signal, so with low barriers new firms enter the market.
3. Because their products are close substitutes, they pull customers away, so each existing firm's demand and marginal revenue curves shift left.
   1. Entry continues until demand is just tangent to $ATC$, where price equals average total cost and only normal profit remains.
4. If firms were making a loss instead, some would exit, shifting demand back to the right until the survivors return to normal profit.
5. At that tangency the firm produces below the lowest point of average total cost, leaving excess capacity, the gap between its output and the lower-cost output it could reach.
   1. Because price still sits above marginal cost, $P > MC$, the firm is also allocatively inefficient.

Evaluating Monopolistic Competition

Whether monopolistic competition serves consumers well comes down to weighing the variety it delivers against the mild inefficiency it carries.

1. Advantages
   1. Variety and choice: differentiation gives consumers many brands, recipes, and styles, which they value and will pay for.
   2. Contestability and innovation: low barriers keep the threat of entry alive, pushing firms to keep costs down and to innovate.
2. Disadvantages
   1. Allocative inefficiency: a sliver of market power keeps price above marginal cost, so output is below the social optimum.
   2. Excess capacity: the long-run tangency leaves the firm on the falling part of average cost, so it never reaches minimum average cost.
3. The inefficiencies are real but limited, because free entry competes abnormal profit away, so prices stay well below a monopoly's and the excess capacity is, in effect, the price paid for variety.