Offer one reason why a monopolistically competitive firm might be productively inefficient.

Monopolistic competition is an interesting market structure because it combines both features of monopoly and perfect competition. On the one hand, firms are price makers and can charge any price they want. On the other hand, it's easy for firms to enter the market as the barriers to entry are low. How to distinguish monopolistic competition from monopoly and perfect competition?

What is monopolistic competition?

Monopolistic competition is a type of market structure where many firms compete by selling slightly differentiated products. This market structure combines the features of both perfect competition and monopoly.

As in perfect competition, monopolistic competition has the following characteristics:

• A large number of firms in the market.
• Low or no barriers to entry and exit.
• The availability of short-term abnormal profits.

However, it also resembles monopolies in many ways:

• Downward sloping demand curve due to product differentiation.
• The ability to control the prices (market power).
• The demand doesn't equal marginal revenue.

Monopolistic competition diagram

Let’s see how monopolistic competition works with some diagrams.

Short-run profit maximisation

In the short run, a firm in monopolistic competition can make abnormal profits. You can see short-run profit maximisation illustrated in Figure 1 below.

Figure 1. Short-run profit maximisation in monopolistic competition, StudySmarter Originals

Note that we draw the demand curve for individual firms, rather than the whole market as in perfect competition. This is because in monopolistic competition each firm produces a slightly differentiated product. This leads to different demands as opposed to perfect competition, where the demand is the same for all firms.

Due to product differentiation, firms are not price-takers. They can control the prices. The demand curve is not horizontal but sloping downward just like for the monopoly. The average revenue (AR) curve is also the demand (D) curve for a company's output as shown in Figure 1.

In the short run, companies in monopolistic competition will make abnormal profits when the average revenue (AR) exceeds the average total costs (ATC) as shown in the light green area in Figure 1. However, other firms will see that the existing firms are making profits and enter the market. This erodes the abnormal profits gradually until only the firms make normal profits in the long run.

Normal profits occur when the total costs equal a firm's total revenues.

A firm makes abnormal profits when the total revenues exceed the total costs.

In the long run a firm in monopolistic competition can only make normal profits. You can see long-run profit maximisation in monopolistic competition illustrated in Figure 2 below.

Figure 2. Long-run profit maximisation in monopolistic competition, StudySmarter Originals

As more firms enter the market, each firm’ revenue will reduce. This causes the average revenue curve (AR) to shift inward to the left as illustrated in Figure 2. The average total costs curve (ATC) will remain the same. As the AR curve becomes tangent to the ATC curve, the abnormal profits disappear. Thus, in the long run, firms in monopolistic competition can only make normal profits.

Characteristics of monopolistic competition

There are four key features of monopolistic competition:

• A large number of firms.
• Product differentiation.
• Firms are price makers.
• No barriers to entry.

Let’s take a closer look at each of these features.

A large number of firms

There is a large number of firms in monopolistic competition. However, due to product differentiation, each firm maintains a limited amount of market power. This means that they can set their own prices and won't be affected much if other firms increase or lower their prices.

When shopping for snacks in the supermarket, you’ll see many brands selling different types of crisps with various sizes, flavors, and price ranges.

Product differentiation

Products in monopolistic competition are similar but not perfect substitutes for each other. They have different physical attributes such as taste, smell, and sizes, or intangible attributes such as brand reputation and eco-friendly image. This is known as product differentiation or unique selling points (USP).

Firms in monopolistic competition do not compete in terms of price. Instead, they take up non-price competition in various forms:

• Marketing competition such as the use of exclusive outlets to distribute one’s product.
• The use of advertising, product differentiation, branding, packaging, fashion, style, and design.
• Quality competition such as providing post-sales services for customers.

Product differentiation in monopolistic competition can also be classified into vertical differentiation and horizontal differentiation.

• Vertical differentiation is the differentiation via quality and price. For example, a company can split the product portfolio among different target groups.
• Horizontal differentiation is the differentiation via style, type, or location. For example, Coca-Cola can sell its beverage in glass bottles, cans, and plastic bottles. While the product type is different, the quality is the same.

Firms are price makers

The demand curve in monopolistic competition is downward sloping instead of being horizontal as in the perfect competition. This means firms retain some market power and control the prices to a certain extent. Due to product differentiation through marketing, packaging, branding, product features, or design, a firm can adjust the price in its favor without losing all the customers or affecting other firms.

No barriers to entry

In monopolistic competition, there are no barriers to entry. Thus, new firms can enter the market to take advantage of short-term abnormal profits. In the long run, with more firms, the abnormal profits will compete away until only normal profits are left.

There are many real-life examples of monopolistic competition:

Bakeries

While bakeries sell similar pastries and pies, they may differ in terms of price, quality, and nutritional value. Those that have a more unique offering or service may enjoy higher customer loyalty and profits than the competitors. There are low barriers to entry as anyone can open a new bakery with sufficient funding.

Restaurants are prevalent in every city. However, they vary in terms of price, quality, environment, and extra services. For example, some restaurants can charge premium prices as they have an award-winning chef and a fancy dining environment. Others are on a cheaper price end due to lower quality products. Thus, even if the restaurant dishes are made from similar ingredients, they are not perfect substitutes.

Every country has hundreds to thousands of hotels. They offer the same service: accommodation. However, they are not quite the same as different hotels are situated in different locations and offer different room layouts and services.

Monopolistic competition is both productively and allocatively inefficient in the long run compared to perfect competition. Let’s explore why.

Figure 3. Excess capacity in monopolistic competition in the long run, StudySmarter Originals

As discussed before, in the long run, with more firms entering the market, the abnormal profits in monopolistic competition will be eroded until the firms only make normal profits. When this happens, the profit-maximising price equals the average total cost (P = ATC) as shown in Figure 3.

Without the economies of scale, firms have to produce a lower level of output at a higher cost. Note, in Figure 3, that the cost at Q1 is above the lowest point of the average total cost curve (point C in Figure 3 above). This means that the firms in monopolistic competition will suffer from productive inefficiency as their costs are not minimised. The level of productive inefficiency can be expressed as an ‘excess capacity,’ marked by the difference between Q2 (the maximum output) and Q1 (the output a firm can produce in the long run). The firm will also be allocatively inefficient as the price is greater than the marginal cost.

Productive efficiency occurs when a firm produces maximum output at the lowest possible cost.

Allocative efficiency occurs when a firm produces output where the price is equal to marginal cost.

The economic welfare effects of monopolistic competition are ambiguous. There are several inefficiencies in monopolistically competitive market structures. However, we could argue that product differentiation increases the number of product choices available to consumers, thereby improving economic welfare.

Monopolistic Competition - Key takeaways

• Monopolistic competition is a large number of firms in the market selling slightly differentiated products.
• Firms are price-makers and their demand curve is sloping downward instead of being horizontal as in perfect competition.
• There are no barriers to entry so firms can enter at any time to take advantage of the abnormal profits.
• In monopolistic competition, firms can earn abnormal profits in the short run as long as the average revenue curve is above the average total cost curve. When the average revenue curve becomes tangent to the average total cost curve, the abnormal profits disappear and the firms only make normal profits.
• Firms in monopolistic competition suffer from productive and allocative inefficiency.