monopolistic competition

Monopolistic Competition – A‑Level Economics (Cambridge 7.6)

1. Definition and Core Economic Concepts

• Market structure: Many sellers and many buyers.
• Product differentiation: Firms sell goods that are similar but not identical (brand, quality, style, location, etc.).
• Scarcity & choice: Differentiation is a response to scarce resources – firms choose the most profitable combination of product features and price at the margin.
• Free entry and exit (long‑run): No permanent legal or natural barriers; firms can freely join or leave the market.
• Independent decision‑making: Each firm treats rivals’ prices as given and decides its own price and output.
• Demand curve: Downward‑sloping because the firm’s product is not a perfect substitute for any other.

2. Product Differentiation and the Firm’s Demand Curve

The demand curve faced by an individual firm is elastic (|ε| > 1) but not perfectly elastic. Its elasticity depends on:

• Degree of differentiation – the more unique the product, the less elastic the demand.
• Number of close substitutes – more substitutes → higher elasticity.
• Consumer loyalty and brand perception.

For a linear demand curve we can write:

$$P = a - bQ$$

where a and b are positive constants and Q is the quantity sold by the firm.

3. Barriers to Entry

Although the long‑run equilibrium assumes “free entry”, the syllabus requires students to recognise the three main types of barrier that can prevent this:

• Legal barriers: licences, patents, zoning regulations.
• Cost barriers (natural): economies of scale, high start‑up capital.
• Market barriers: strong brand loyalty, advertising intensity, network effects.

If any of these are substantial, firms may earn positive economic profit in the long run, moving the market away from the zero‑profit equilibrium.

4. Deriving Marginal Revenue (MR)

Total revenue (TR) is:

$$TR = P \times Q = (a - bQ)Q = aQ - bQ^{2}$$

Marginal revenue is the derivative of TR with respect to Q:

$$MR = \frac{d(TR)}{dQ}= a - 2bQ$$

Key point: MR has twice the slope of the demand curve. This relationship holds for any linear demand; for non‑linear demand the same principle applies – MR is the derivative of the TR function.

5. Short‑Run Profit Maximisation

1. Rule: Choose output where MR = MC.
2. Price‑setting vs. price‑taking: In perfect competition firms are price‑takers (P = MR). In monopolistic competition firms are price‑setters because MR < P for any positive output.
3. Procedure (any functional form):
   1. Write down the demand (or inverse demand) function.
   2. Derive TR and then MR by differentiation.
   3. Set MR equal to the marginal cost (MC) function and solve for Q_SR.
   4. Substitute Q_SR back into the demand curve to obtain the price P_SR.
   5. Calculate profit: π = P_SR·Q_SR – TC(Q_SR).

Numeric illustration (linear example)

Assume:

• Demand: \(P = 12 - Q\) (\(a = 12,\; b = 1\))
• Marginal cost: \(MC = 2Q\)
• Total cost: \(TC = 5 + Q^{2}\) (so \(FC = 5\), \(VC = Q^{2}\))

Set MR = MC:

$$a - 2bQ = 2Q \;\Longrightarrow\; 12 - 2Q = 2Q \;\Longrightarrow\; Q^{SR}=3$$

Price from the demand curve:

$$P^{SR}=12 - 3 = 9$$

Profit:

$$TC(3)=5+3^{2}=14$$ $$\pi = 9 \times 3 - 14 = 27 - 14 = 13$$

The firm earns a positive economic profit of 13 units in the short run.

6. Long‑Run Equilibrium

• Free entry and exit drive economic profit to **zero**.
• At the profit‑maximising output, price equals average total cost: $$P^{LR}=ATC(Q^{LR})$$
• MR = MC still holds, but the firm’s demand curve is **tangent** to the ATC curve at the output where zero profit is earned.
• Consequences:
  • Output is lower and price is higher than in perfect competition – the firm operates with excess capacity (productive inefficiency).
  • Because \(P^{LR}>MC\), the market is also allocatively inefficient.

7. Efficiency Considerations

• Productive inefficiency (excess capacity): Firms do not produce at the minimum point of the ATC curve.
• Allocative inefficiency: Price exceeds marginal cost (\(P > MC\)), so the quantity supplied is below the socially optimal level.

8. Comparison with Other Market Structures

Feature	Perfect Competition	Monopolistic Competition	Monopoly
Number of firms	Very many	Many	One
Product type	Homogeneous	Differentiated	Unique
Entry/exit	Free	Free in the long run (unless barriers exist)	Barriers (legal, cost, strategic)
Decision‑making	Price‑taker (price given)	Independent – sets price where MR = MC	Price‑setter (P > MC)
Demand curve faced by firm	Perfectly elastic	Downward sloping (elastic but not perfectly)	Downward sloping
Pricing strategy	No discretion (P = MC)	Sets price where MR = MC (P > MC)	Sets price above MC (P > MC)
Advertising/branding	Unimportant	Crucial – creates perceived differences	Usually unnecessary (product already unique)
Long‑run profit	Zero economic profit	Zero economic profit (if entry is truly free)	Positive economic profit (if unregulated)
Allocative efficiency (P = MC)	Yes	No (P > MC)	No (P > MC)
Productive efficiency (min ATC)	Yes	No (excess capacity)	No (often above min ATC)

9. Policy Implications

• Facilitate entry: Reduce unnecessary licences, lower zoning restrictions, and avoid anti‑competitive regulations that create artificial barriers.
• Improve consumer information: Mandatory labelling, quality standards, and comparison websites help consumers assess real differences, weakening “brand‑premium” pricing.
• Regulate deceptive advertising: Ensure that product claims are verifiable, so differentiation reflects genuine quality rather than misinformation.
• Encourage innovation: R&D tax credits, grants, and intellectual‑property protection that does not become a barrier to entry promote welfare‑enhancing product improvements.
• Antitrust vigilance: When brand loyalty or network effects become so strong that they block new entrants, competition authorities may need to intervene to preserve contestability.

10. Suggested Diagrams