Monopolistic Competition

A firm might be able to increase its profit by differentiating its products from those of its competitors. Most often, however, the products will still have many properties in common, which makes them close substitutes. Popular examples include Coca Cola and other cola- or soft drinks, and different brands of laundry detergent. This behavior makes the firm a monopolist on their own product, for instance on Coca Cola, but with customers that have close substitutes to choose from, for instance Pepsi Cola. If the firm raises the price, some customers would move to the substitute, but not all of them. Similarly, if the firm would lower the price, they would attract some of the competitors’ customers, but not all of them. Note that, if the products were identical, we would have an oligopoly. If the firms, in addition, compete with prices, we would have a Bertrand situation and none of the firms would make a profit.

Conditions for Monopolistic Competition

Criteria for monopolistic competition include

• There are several producers in the market
• The products are not identical, but they are close substitutes.
• There are no barriers to entry.

These conditions imply that each firm will face a downward sloping demand curve: If they increase the price, they will sell less and if they decrease it, they will sell more. However, the demand curve is very elastic since there are close substitutes, so the customers will react quite strongly to price changes and quickly shift over to (or from) the competitors.

Market Equilibrium

Short Run
In the short run, no new firms can establish themselves in the market (since the quantity of capital, by the definition of the short run, is fixed). To the left in Figure 15.1, D_S is the short-run demand curve an individual firm faces in a market with monopolistic competition, and MR_S is the corresponding marginal revenue. Similar to a monopoly, the MR curve is twice as steep as the demand curve. The firm, as always, maximizes its profit by choosing the quantity, q₁*, that makes MC = MR_S. Since the average cost, AC, is below the price at that quantity, the firm makes a profit, q₁*(p₁* - AC), corresponding to the grey rectangle in the figure.

Long Run
Since the firms make a short run profit and there are no barriers to entry, new firms will establish themselves in the market. Thereby, the demand curve that the individual firm faces changes so that at each price it is now possible to sell a smaller number of goods. This means that to the right in Figure 15.1, where we have the situation in the long run, the demand curve, D_L, and the marginal revenue, MR_L, have shifted inwards (see the arrows in the figure).

How far do they shift? They shift until there is no profit. Remember that, the firms choose the quantity that maximizes profit, i.e. the quantity that makes MC = MR. The demand curve, DL, will consequently shift until the quantity where the firm maximizes its profit, q₂*, is such that the price the firm can take for the good, p₂*, is exactly equal to the average cost, AC. At that point, the profit is q₂*(p₂* - AC) = 0.
Note that the production is not efficient. Even in the long run we have that p > MC, which means that the cost of producing additional goods is lower than the consumers’ valuations. If we compare to the results for perfect competition in the long run, we see that one difference is that long-run production in the case of monopolistic competition does not end up at the lowest
point of the AC curve. This, in turn, means that there are unexploited economies of scale ). Had we had fewer firms in the market, and thereby larger firms to satisfy the demand, they would have come closer to the lowest point on the AC curve. On the other hand, we would then have had fewer (close substitute) products between which to choose. It is not possible,
without a more detailed analysis, to say what balance between these two – lower unit costs or more products to choose from – that is the best for the consumers.

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