MONOPOLISTIC COMPETITION— CHARACTERISTICS, OUTPUT AND PRICING DECISIONS

monopolistic competition is a imperfect competitive market where there are many buyers and sellers of differentiated goods.

Monopolistic combination can be said to be a combination of mini-monopoly and mini-perfect competition.

Characteristics Of Monopolistic Competition

Monopolistic competition is characterized by the following:

1. Many buyers and sellers:  As with perfect competition, there are many sellers and buyers in the market.

The only difference is that buyers and sellers in the monopolistic competition have imperfect knowledge of market conditions whereas their perfect competitive counterparts have perfect knowledge of market conditions

2. Differentiated goods: Goods sold in monopolistic competition are slightly differentiated.

Product differentiation may be real (like packaging, brand name) or imagined. Product differentiation by imagination in that the product is differentiated in the minds of the consumers

For example, if many individuals were blindfolded and asked to tell the difference between a variety of drinks. Not many will be able to tell the difference between these drinks. This highlights product differentiation by imagination

3. Demand curve: The demand curve faced by monopolistic competition is not a horizontal straight line, rather it is downward-sloping.

The intuition for this is very simple. As with perfect competition, the monopolistic competitive firms have competitors who sell substitute goods. 

However, these goods are not perfect substitutes as they are different from one another. 

Hence, the monopolistic competitor's demand curve will be downward sloping since he has some form of market power over his goods (due to product differentiation)

4. Freedom of entry and exit: No barrier to entry and exit exists in monopolistic competition. 

This is one characteristic that monopolistic competitive firm shares with perfect competitive firms.

4. Price maker: in monopolistic competition, products are differentiated. Each monopolistic competitive firm is selling slightly different goods. This means the monopolistic competitive firm has a sort of mini-monopoly and market power over its product.

Monopolistic competition resembles monopoly in this respect.

5. Price and marginal revenue:  Monopolistic competitive firms are faced with a downward-sloping demand curve. To sell additional units of his goods, he would have to reduce the price(law of demand). Hence price will be greater than marginal revenue. 

Output and Pricing Decisions In a Monopolistic Competition

Like all firms, monopolistic competitor seeks to maximize profit. This would be done by comparing the marginal revenue and the marginal cost.

All profit-maximizing firms will produce at the point where marginal revenue equals marginal cost.

In the short run, a monopolistic competitor can earn economic profits. In this case, the price will be greater than the average cost at the profit-maximizing output. 

It is also possible for monopolistic competitors to suffer economic loss, that is, average cost greater than the price at the output where marginal revenue equals marginal cost

Earning economic profit is, however, not a feature of monopolistic competition in the long run. This can be inherently attributed to the freedom of entry and exit.

The intuition for the assumption is very simple. If firms in monopolistic competition are earning economic profit in the short run, more firms will enter the market. 

New entrants implies that the demand faced by each monopolistic competitor will decrease. That is, the demand curve of monopolistic competitors will shift to the left. 

And you know, the marginal revenue will decrease as demand decreases. Hence the process of entry will eventually drive economic profit to the zero-profit region.

Now, think of what would happen if monopolistic competitive firms are suffering an economic loss in the short run?

As expected,  more Firms will leave the market. As more firms leave the market, the demand curve for the individual firms will shift outward.

This continues until zero profit exists in the market. Thus, the process of entry and exit will cause a firm in monopolistic competitors to earn zero profit in the long run.

Monopolistic competition and Efficiency

Being a market structure that earns zero profit in the long run, you would have expected that monopolistic competitors are productively efficient in the long-run equilibrium. This is, however, not exactly the case.

Productive efficiency, as I have always say, is producing without waste so that the choice is on the production possibility curve

Another way of defining productive efficiency is producing at the lowest possible cost so that average cost equals marginal cost.

Given that the price received by a monopolistic competitive firm is usually greater than its marginal revenue at all output greater than one.

Given also that monopolistic competitors maximize profit by producing where marginal revenue equals marginal cost. 

Thus, monopolistic competitors are not productive efficient as their price will be greater than MC and the minimum point of the average cost.

The monopolistic competitive firms are also not allocatively efficient because of the same reason. Allocative efficient means producing the goods that are most wanted by the consumer so that price equals marginal cost.

Just I said earlier, the price received by monopolistic competitors is greater than their marginal revenue. You know monopolistic competitor maximizes profit where marginal revenue is equal to marginal cost.

Hence, monopolistic competitive firms are allocative inefficient as they will be producing where price greater than marginal cost. 

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There you have it! To summarize, here are seven things you should know about the monopolistic competition.

1. Unlike perfect competition, product differentiation exists in monopolistic competition.

2. The demand curve faced by a monopolistic competitor is downward sloping.

3. Unlike their perfect competition counterpart, monopolistic competitors are price makers.

4. Like all firms, monopolistic competitors maximize profit where marginal revenue equals marginal cost.

5. Monopolistic competitors are likely to earn zero profit in the long run.

6. It is possible for a monopolistic competitor can suffer economic loss in the short run.

7. Monopolistic competitor is never productive or allocative efficient.

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