3.4.3 Monopolistic Competition

Edexcel A-Level Economics (9EC0) | Theme 3.4.3

Specification Coverage: Edexcel unit 3.4.3 - Monopolistic Competition. Students should be able to understand the main characteristics of monopolistic competition, explain how short-run profit or loss changes into long-run normal profit, and analyse the productive and allocative inefficiencies present in long-run equilibrium.

Key Characteristics

  • There are many small firms.
  • Products are differentiated through factors such as branding, quality, location, or service. This is the key feature.
  • There are low barriers to entry and exit.
  • Firms have some price-setting power, so they are price makers because of product differentiation.

The Firm's Demand Curve

Because products are differentiated, each firm faces a downward-sloping demand curve, which is also its average revenue (AR) curve.

This gives each firm a small degree of market power.

Short-Run Equilibrium: Profit and Loss

The firm maximises profit where \( MC = MR \).

Supernormal profit in monopolistic competition diagram
Figure 1: A monopolistically competitive firm can earn supernormal profit in the short run if \( AR > AC \) at the profit-maximising output.

Firms can also make losses in the short run if \( AR < AC \) at the profit-maximising output.

Long-Run Equilibrium: Normal Profit Only

Because there are low barriers to entry and exit, the market adjusts to a long-run equilibrium where all firms earn normal profit.

If firms earn short-run supernormal profit, this attracts new entrants. That reduces the market share of existing firms and shifts each firm's demand curve left until supernormal profit is removed.

The opposite happens if firms make losses: some firms leave the market, and the remaining firms experience a rightward shift in demand.

Normal profit in monopolistic competition diagram
Figure 2: A monopolistically competitive firm can earn normal profit in the long run if \( AR = AC \) at the profit-maximising output.

Efficiency in Long-Run Equilibrium

Productive efficiency: No. The firm does not produce at the minimum point of the AC curve, so there is excess capacity.

Allocative efficiency: No. At long-run equilibrium, \( P > MC \), so the firm is under-producing relative to the social optimum.

Dynamic efficiency: Possible, but limited. Some supernormal profit may be earned in the short run and used for innovation, but it is competed away in the long run.

Exam Preparation

  • List the characteristics of monopolistic competition, especially product differentiation and low barriers to entry.
  • Draw the long-run equilibrium diagram, showing the AR curve tangent to the AC curve.
  • Explain the adjustment process from short-run profit or loss to long-run normal profit.
  • Analyse why the firm is neither productively nor allocatively efficient in the long run.
  • Compare monopolistic competition with perfect competition: both earn normal profit in the long run, but monopolistic competition has differentiated products and is inefficient.