Monopolistic competition

Monopolistic competition refers to a market structure where many firms offer products or services that are similar, but not perfect substitutes.
It is characterised by product differentiation, where firms seek to distinguish their products from those of their rivals.

Characteristics of Monopolistic Competition

Many sellers and buyers: There are a significant number of firms, but each is too small to affect the market price by acting alone.
Product differentiation: Each firm produces a product that is slightly different from those of its competitors. This gives each firm a tiny amount of monopoly power as it has some control over the price.
Freedom of entry and exit: Firms are free to enter or exit the market. This means that profits are only possible in the short term.

Short Run and Long Run

In the short run, firms can make supernormal profits or losses. If a firm is making supernormal profit, more firms will enter the market, attracted by these profits.
In the long run, as more firms enter the market, the demand for the existing firm’s product will decrease and it will need to lower its price. This reduces the supernormal profit. When there are no more supernormal profits to be made, firms will stop entering the market – this is long-run equilibrium.

Efficiency in Monopolistic Competition

This market structure is inefficient. Neither productive nor allocative efficiency is achieved.
Due to product differentiation, firms can charge a price above the marginal cost (P > MC), leading to allocative inefficiency.
In the long run, firms operate at an output less than the cost-minimising output, leading to productive inefficiency.

Advantages of Monopolistic Competition

Variety and choice: Due to product differentiation, consumers have a wide range of products to choose from.
There may be scope for innovation and creativity as firms try to differentiate their products.

Disadvantages of Monopolistic Competition

Inefficiency: Firms do not produce at the lowest point of their average cost curve, leading to productive inefficiency. They also charge a price higher than marginal cost, causing allocative inefficiency.
Advertising costs: Firms often spend significantly on advertising to differentiate their products, driving up the average cost.

To summarise, monopolistic competition is a common market structure characterised by product differentiation, lack of efficiency, and high levels of consumer choice and non-price competition.