1.5.4 Monopolistic Competition — Practice Questions

Seven original multiple-choice questions on monopolistic competition, written to the style and difficulty of AQA Paper 3 Section A. Every question carries a full worked model answer.

7 questions AQA A-Level Multiple choice Model answers included

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1. 1. The characteristic that distinguishes monopolistic competition from perfect competition is

   Definition in context

   Select one answer

   A High barriers to entry and exit.

   B Only a small number of firms in the market.

   C Products that are differentiated rather than identical.

   D The absence of any supernormal profit in the short run.
   Show model answer

   Answer: C (Products that are differentiated rather than identical.). Both structures have many firms and low barriers to entry. What separates them is the product: perfectly competitive firms sell homogeneous goods, while monopolistically competitive firms differentiate theirs through branding, quality, features or location. That differentiation gives each firm a little market power and a downward-sloping demand curve.

   Why the other options are wrong

   • A — Barriers are low in monopolistic competition, just as in perfect competition. It is that shared feature which drives both to normal profit in the long run.
   • B — Monopolistic competition has many firms, each with a small market share. A small number of large firms is oligopoly.
   • D — Both structures allow supernormal profit in the short run and eliminate it in the long run. The short-run position is not what distinguishes them.

2. 2. A firm in monopolistic competition faces a downward-sloping demand curve because

   Applied reasoning

   Select one answer

   A Barriers to entry prevent rivals from undercutting it.

   B Buyers have imperfect information about every rival's price.

   C It is the only supplier of the product in the market.

   D Its product is differentiated, so some buyers prefer it.
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   Answer: D (Its product is differentiated, so some buyers prefer it.). Because the product is not identical to its rivals', a firm that raises its price does not lose every customer — some buyers value the brand, the quality or the location enough to stay. That partial loyalty is what makes the demand curve slope downwards rather than lie flat, and it gives the firm a limited ability to set its own price. It remains limited because close substitutes are readily available.

   Why the other options are wrong

   • A — Barriers to entry are low in this structure, which is exactly why long-run profit is competed away. They are not what gives the firm its price-setting power.
   • B — Imperfect information may exist in real markets, but the model attributes the downward slope specifically to product differentiation.
   • C — A sole supplier is a monopoly. Monopolistic competition has many firms selling similar but distinguishable products.

3. 3. Firms in a monopolistically competitive market are earning supernormal profit in the short run. Sketching the firm before and after, the most likely long-run adjustment is that

   Applied reasoning Sketch to solve

   Select one answer

   A Barriers to entry rise, protecting the existing firms' profit.

   B New firms enter, demand for each firm falls, and profit returns to normal.

   C New firms enter, demand for each existing firm rises, and profit increases.

   D Some firms leave, and the remaining firms earn higher profit.
   Show model answer

   Answer: B (New firms enter, demand for each firm falls, and profit returns to normal.). Sketch the firm with a downward-sloping AR curve above its AC curve at the profit-maximising output — that gap is the supernormal profit.
   Because barriers to entry are low, that profit attracts new firms selling close substitutes. Each existing firm's share of the market shrinks, so its demand curve shifts left and becomes more elastic. Entry continues until AR is just tangent to AC at the profit-maximising output, leaving only normal profit.
   The mechanism is the same as in perfect competition — free entry competes profit away — but the outcome differs, because the firm ends up on the downward-sloping part of its AC curve rather than at the bottom of it.

   Why the other options are wrong

   • A — Barriers are a structural feature of the market, and in monopolistic competition they are low. Firms cannot raise them at will to defend their profits.
   • C — Entry divides the same total demand among more firms, so demand for each existing firm falls rather than rises.
   • D — Firms exit when they are making losses. Supernormal profit attracts entry.

4. 4. In long-run equilibrium, a firm in monopolistic competition earns

   Applied reasoning

   Select one answer

   A Normal profit, with average revenue tangent to average cost.

   B Normal profit, with price equal to marginal cost.

   C Supernormal profit, because its product is differentiated.

   D Supernormal profit, because barriers to entry are high.
   Show model answer

   Answer: A (Normal profit, with average revenue tangent to average cost.). Free entry drives supernormal profit to zero, so the firm ends at AR = AC — the demand curve just touching the average cost curve at a single point of tangency. Because AR slopes downwards, that tangency can only occur on the falling section of the AC curve, to the left of its minimum. That geometric detail is what generates both of the inefficiencies in this market structure.

   Why the other options are wrong

   • B — Price equal to marginal cost is allocative efficiency, and it does not hold here. The firm's downward-sloping demand curve puts MR below AR, so profit maximisation leaves price above marginal cost.
   • C — Differentiation gives some short-run market power, but it does not stop new differentiated rivals entering. Profit is competed away all the same.
   • D — Barriers to entry are low in monopolistic competition, which is precisely why supernormal profit cannot persist.

5. 5. In long-run equilibrium, a firm in monopolistic competition is

   Applied reasoning

   Select one answer

   A Allocatively efficient but not productively efficient.

   B Both allocatively and productively efficient.

   C Neither allocatively nor productively efficient.

   D Productively efficient but not allocatively efficient.
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   Answer: C (Neither allocatively nor productively efficient.). Both conditions fail, and for related reasons.
   Productive efficiency requires production at the minimum of the average cost curve. The tangency between a downward-sloping AR and AC can only happen on the falling part of AC, so the firm produces less than that and at a higher average cost — it carries excess capacity.
   Allocative efficiency requires P = MC. With MR below AR, profit maximisation at MC = MR leaves price above marginal cost, so too little is produced from society's point of view.
   The offsetting benefit is variety: consumers get a choice of differentiated products, which the perfectly competitive outcome does not offer.

   Why the other options are wrong

   • A — Allocative efficiency fails as well, because the downward-sloping demand curve puts price above marginal cost at the profit-maximising output.
   • B — This is the perfectly competitive long-run outcome, and it is the benchmark against which monopolistic competition falls short on both counts.
   • D — Productive efficiency fails too. Excess capacity is the standard criticism of this market structure.

6. 6. Which one of the following markets is the best example of monopolistic competition?

   Applied reasoning

   Select one answer

   A Independent restaurants in a large city.

   B Mains water supply to households in one region.

   C Supermarket chains competing nationally.

   D Wheat sold on a global commodity exchange.
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   Answer: A (Independent restaurants in a large city.). Independent restaurants tick every box: many firms, each with a small share; differentiated products distinguished by cuisine, quality, atmosphere and location; and low barriers to opening or closing one. Hairdressers and clothing brands are the other standard examples.

   Why the other options are wrong

   • B — A single water supplier with no substitute and enormous infrastructure costs is the classic natural monopoly.
   • C — A handful of large chains dominating national sales behind high barriers is an oligopoly.
   • D — Wheat traded on an exchange is a homogeneous commodity with many buyers and sellers — the closest real-world approximation to perfect competition.

7. 7. A firm in monopolistic competition invests heavily in branding and advertising. The main economic purpose of this spending is to

   Applied reasoning

   Select one answer

   A Lower the firm's average cost of production.

   B Make demand for its product less price elastic.

   C Persuade rival firms to raise their prices.

   D Reduce the barriers to entry facing the firm.
   Show model answer

   Answer: B (Make demand for its product less price elastic.). Branding deepens product differentiation, persuading buyers that this product has no close equivalent. The more strongly they feel that, the fewer of them switch away when the price rises — so demand becomes less price elastic and the firm gains room to charge more without losing its customers. It is an attempt to hold on to market power that free entry would otherwise erode.

   Why the other options are wrong

   • A — Advertising is a cost, so it raises average cost in the short term. Any cost benefit would come indirectly, through selling a larger volume.
   • C — Rivals set their own prices, and in a market with many firms each is far too small to influence the others. Anticipating rivals' reactions is an oligopoly concern.
   • D — Barriers to entry are a feature of the market rather than something a firm sets for itself, and a firm would want them higher, not lower.