Monopolistic competition equilibrium
Differentiated products, free entry.
Assumptions:
- MANY sellers and buyers.
- DIFFERENTIATED PRODUCTS — real or perceived differences (brand, location, service, quality).
- FREE ENTRY AND EXIT — no significant barriers.
- REASONABLY good information (less perfect than PC).
Real-world examples: independent restaurants, coffee shops, hair salons, fashion brands, mobile apps, restaurants, fashion clothing.
Each firm has SOME MARKET POWER because of product differentiation. Demand curve facing single firm is DOWNWARD-SLOPING but ELASTIC (close substitutes available — if you raise price, customers switch to similar products).
Short-run equilibrium. Firm maximises profit where MR = MC. Three possible outcomes:
- Supernormal profit: P > ATC at chosen Q.
- Normal profit: P = ATC.
- Losses: P < ATC.
Long-run adjustment. Free entry attracts new differentiated competitors when supernormal profits exist. Each entry takes market share from incumbents → individual firm's demand curve shifts LEFT and becomes MORE ELASTIC (more substitutes available).
Long-run equilibrium. Each firm's demand curve is TANGENT to its ATC curve.
- At profit-max output (MR = MC), P = ATC at that Q.
- Each firm earns NORMAL PROFIT.
- BUT this tangency occurs BEFORE the minimum of ATC (because demand is downward-sloping, ATC is U-shaped, and tangency happens on the downward part).
Why? Tangency requires same slope. ATC slope at min = 0 (horizontal). D slope is negative everywhere. So tangency can't be at min ATC; must be before.
Comparison with perfect competition.
| Feature | Perfect competition | Monopolistic competition |
|---|---|---|
| Number of firms | Many | Many |
| Products | Identical | Differentiated |
| Firm demand | Horizontal | Downward-sloping (elastic) |
| LR profit | Normal | Normal |
| Productive efficiency | YES (P = min ATC) | NO (excess capacity) |
| Allocative efficiency | YES (P = MC) | NO (P > MC) |
| Variety | None | YES |
Excess capacity. Difference between equilibrium Q and the Q that would minimise ATC. Firm could produce more cheaply per unit but doesn't because of downward-sloping demand.
Efficiency-variety trade-off. Monopolistic competition is INEFFICIENT (excess capacity, P > MC), BUT consumers get VARIETY. Is the efficiency loss worth the variety benefit?
Most economists conclude: YES. Consumers value choice; the efficiency cost is modest. The framework explains why we see so many restaurants, brands, etc. — consumers want differentiation.
Reality check. Most real-world markets approximate monopolistic competition more than perfect competition or monopoly. PC is too restrictive; monopoly too rare. Mon comp covers most consumer markets.
- Many firms + differentiation + free entry.
- Downward-sloping firm demand (elastic).
- LR: D tangent to ATC; normal profit.
- Excess capacity (P at tangency < min ATC).
- Not allocatively efficient (P > MC).
- Variety as compensating benefit.