Monopolistic Competition Highlighted Sections Monopolistic Competition in the Short-Run Monopolistic Competition in the Long-Run Advertising in Monopolistically Competitive Markets Monopolistic Competition in the Short-Run - (Back to Top) Monopolistic competition consists of a market where there are MANY firms, all selling products that are similar but distinguishable. The difference between monopolistic and perfect competition is that the product in perfect competition is NOT distinguishable (like wheat, for instance).   Because of product differentiation in monopolistically competitive markets, firms are able to exert control over the price of their individual variety of product (for example, one restaurant can control the prices on their OWN menu, because no other restaurant sells dishes that are exactly alike). Therefore, the demand curve facing firms in monopolistically competitive markets is downward sloping, just like the demand curve facing monopoly firms.   It is also important that you remember the difference between monopolistic competition and monopoly (after all, the graphs for the two look almost exactly alike). Monopoly firms face a downward sloping demand curve because they are the ONLY seller in the market, and the demand curve is the MARKET demand curve for their product. Monopolistically competitive firms (of which there are MANY in the market) face downward sloping demand because nobody is able to sell a perfect substitute for their product. Java Powered! There are two possibilities for the monopolistically competitive firm in the short-run. In the figure at right, move the slider all the way to the right. When demand is strong (shifted well right) the monopolistically competitive firm is able to sell where P > ATC. In this case, the firm makes profits equal to the size of the gray area in the figure. (Note that monopolistically competitive firms, like all firms, still maximize profits by producing where MR = MC.) In the figure at right, move the slider all the way to the left. When demand is low (shifted well left) the monopolistically competitive firm has to sell where P < ATC. In this case, the firm loses money, and the size of the loss is equal to the size of the red area. NOTE: Monopolistically competitive firms still have to concern themselves with loss minimization in the short-run. Even though the AVC curve is NOT shown in this figure, monopolistically competitive firms still shutdown operations when P < AVC. Monopolistic Competition in the Long-Run - (Back to Top) Java Powered! For long-run analysis, do NOT move the slider in the figure at right. The original position for this figure IS the monopolistically competitive firm's long-run equilibrium.   Just like perfect competition, notice that monopolistic competition leads to an equilibrium where the firm makes zero economic profits.   Q: Move the slider to the right. Why can't this be a long-run equilibrium in a monopolistically competitive market? A: Because the firm is making positive economic profits (as shown by the gray area). If firm's in a monopolistically competitive market are making positive economic profits, new firms will enter the market. Remember that, like perfect competition, monopolistic competition is a type of market where there is free entry and exit of firms. It is the entry of new firms (competitors) that will reduce the demand for this firm's product (the demand falls because the firm's market share falls as the level of competition increases).   Q: Move the slider to the left. Why can't this be a long-run equilibrium in a monopolistically competitive market? A: Because the firm is losing money (as shown by the red area), and firm's cannot lose money in the long-run. In this situation, some of the firm's in the monopolistically market will go out of business. As this occurs, the market share of the surviving firms increases (therefore, the demand curve shifts back to the right).   Below, both the perfectly competitive and monopolistically competitive long-run equilibria have been reproduced. Notice that the long-run equilibrium for a monopolistically competitive firm occurs at different point on the ATC curve than that for perfectly competitive firms (for perfectly competitive firms the long-run equilibrium was at the bottom of the ATC curve). As a result, monopolistically competitive firms do NOT produce at their minimum efficient scale. This leads to deadweight losses, much like with monopoly firms. Advertising in Monopolistically Competitive Markets - (Back to Top) Something else that is common to monopolistically competitive markets is the presence of advertising. When firms advertise their total costs increase (shift upward). Arguments can be made both that advertising is beneficial and harmful to consumers (increasing product knowledge versus increasing product cost). Just remember that advertising affects the firms ATC curve (even though this is usually NOT depicted).   When firms fight for increased market share (to shift demand right) this comes at the cost of a larger advertising budget (and a higher ATC curve). When firms exit the market (and the remaining firm's market shares increase) competition is reduced and the pressure of advertising costs may be relieved somewhat (ATC shifts back down). Keep this interaction in mind in your analysis of monopolistic competition. (Back to top)