Monopolistic competition has characteristics of both competition and monopoly. Similar to competition, it has many firms, and free exit and entry. Similar to monopoly, the products are differentiated and each company faces a downward sloping demand curve. Since the company has a differentiated product, it is like a monopolist and faces a negatively-sloped demand curve. In the short-run,
- marginal revenue is always less than demand
- profit is maximized where MR = MC
- profit = (price - average total cost) x quantity
The short-run equilibrium in monopolitic competition is the same as for a monopolist, and businesses may make positive, zero, or negative profits in the short run.
Long Run Equilibrium
In the long run, entry and exit are both possible. If profit is greater than zero, businesses will enter, and each company's market share will fall because of more variety. As a result, each company’s demand curve will decrease, along with price and quantity. If profit is less than zero, businesses will exit, and each company’s market share will increase. This will cause the remaining companies' demand curves to increase, along with the price and quantity.
If profit is equal to zero, there will be no entry into or exit from the industry. In the long run, all the companies' economic profits must be zero.
Monopolistic Competition and Welfare
Let's compare a company in monopolistic competition with a company in perfect competition, where both are in a long-run equilibrium. In both cases, profit equals zero. The two main differences between the two are:
- Excess Capacity
- companies in perfect competition produce where ATC is at a minimum (efficient scale)
- companies in monopolistic competition produce where quantity of output is smaller, and on a downward sloping part of ATC (excess capacity)
- could increase capacity and lower average costs
- Make-up Over Marginal Cost
- for a competitive firm, price = marginal cost
- for a monopolistic competition firm, price > marginal cost
- there is a mark-up above MC even though the firm makes zero profits
Efficient Outcomes and Externalities
When price is greater than marginal cost, the value that consumers place on the last unit is greater than the cost, so the good is under-produced. This leads to a deadweight loss like a monopolist. The number of businesses in the industry may be inefficient, and each time a new business enters, it creates externalities such as,
- Product Variety Externality - consumers get a wider choice of products, and an increase in consumer surplus which is a positive externality
- Business-Stealing Externality - this is a negative externality whereby other businesses lose customers
Since companies do not take these into account, there are no guarantees that there is an optimum number of them in the industry. This means that there may be too few or too many products available on the market.
Product Differentiation through Advertising
Companies that wish to differentiate products often use advertising. Advertising is common with differentiated consumer products, and much less common with homogeneous goods. Forms of advertising include television, radio, direct mail, billboards, etc. Advertising has a wide range of costs and benefits.
One cost of advertising, is that it may be mostly aimed at manipulating tastes of consumers without conveying any useful information. Advertising may also try to create differentiation within products that are actually very similar. Also, advertising tries to make demand curves less elastic, and impedes competition. This then leads to a high markup over marginal cost.
Some benefits to advertising, is that it does convey some useful information such as prices, new products, locations, etc. Advertising may also foster competition by giving more information on pricing and availability. Advertising may also be a “signal of quality”, because willingness to spend money to advertise products may be a sign that the company has confidence in its quality. This makes it rational for consumers to try such products even if content of ads is minimal.