Monopolistic Competition: Explained with Diagrams

Monopolistic competition is a market structure where there is a relatively large number of small firms that sell similar but differentiated products. The barriers to entry and exit are low, and information is imperfect. Sellers hold some degree of market power due to the differentiation of their products. Examples of monopolistic competitive (MPC) markets are bubble tea stores, hawker stores, and salons in Singapore.

In an MPC market structure, there is no market demand curve. With product differentiation and imperfect knowledge among buyers and sellers, there is no single equilibrium price in the market.

Characteristics of MPC Market Structure

1. Large number of small firms relative to market size

The large number of small firms relative to market size is due to the low barriers of entry (point 2). Hence, each firm has a small share of the total market, and holds limited market power. The firm’s ability to markup the prices of their products (setting price above its marginal cost) is limited.

Each firm also acts independently of the other, as it is impossible to consider the reaction of all its rivals. They do not engage in price competition - if a firm retaliates by lowering its price, its gains in revenue will be spread thinly over its many rivals. Thus, firms in MPC can determine their optimal price and output without taking into account the reactions of rival firms.

1. Low barriers to entry and exit

Low barriers to entry and exit arise due to the relatively low overhead costs, relatively easy to copy technology, and relatively mobile factors of production. For example, setting up a bubble tea stall has low start-up costs due to relatively simple cooking equipment, relatively low rental costs, and ease of applying for licenses required. In contrast, a firm in a monopoly like the telecommunications industry experiences extremely high start-up costs and hard to copy technology.

The low barriers result in MPC firms only making normal profits in the long run, because potential entrants to the market can easily enter and erode any supernormal profits the incumbent firms are making. The lack of supernormal profits in the long run limits the MPC firm’s ability from investing in research and development or utilizing large-scale advertising. Hence, product differentiation in an MPC market structure exists, but not to a large extent or scale.

1. Differentiated products

Products are slightly differentiated in the MPC market structure. These differentiating features are in 3 main categories:

• Real physical differences: Close substitutes are still differentiated in minor ways through product development and innovation. Firms may use different raw materials and different processing methods. For example, bubble tea is frequently differentiated through taste because the brewing method of tea and cooking style of boba differ between stores. 

• Imaginary differences: Products can be differentiated through its design, packaging, branding, and promotions. Marketing strategies such as advertising may influence consumers’ belief about the product, which can increase demand and make demand less price elastic, helping the firm gain greater market power.

• Differences in conditions of sale: Differences in location of shops and quality of service can result in product differentiation.

Due to product differentiation, each MPC firm has some market power and is able to control their own prices to an extent. Thus, the demand curve for an MPC firm is downward sloping. However, the demand is relatively price elastic (compared to monopoly or oligopoly) as there are a large number of close substitutes available. To maintain or increase market power slightly, MPC firms continue to engage in product differentiation to the best of their ability.

1. Imperfect information

Buyers and sellers have imperfect information about production methods and prices. For example, in the bubble tea market, firms do not know all the ingredients used by rivals, and buyers do not have complete information on all available prices offered by all stores.

Short Run Equilibrium of MPC Firm

In the short run, an MPC firm may earn supernormal, normal, or subnormal profits. This depends on their cost and revenue conditions. In the case of subnormal profits, firms have to decide whether to shut down or continue production. As long as the firm is able to cover its variable costs (TR > TVC or AR > AVC), it will continue production.

The diagram above shows the case where an MPC firm is earning supernormal profits. At profit-maximising equilibrium output level Q, total revenue is 0PAQ, total cost is 0CBQ, and profits is PCBA.

Long Run Equilibrium of MPC Firm

Due to the low barriers to entry and exit, an MPC firm makes only normal profits in the long run. When existing firms make supernormal profits, new entrants will enter the market and erode these profits. When existing firms make subnormal profits, firms that are unable to cover their total variable cost will shut down and exit the market.

Adjustment from Short Run Supernormal Profits to Long Run Normal Profits

Assume that the profit-maximising firm in MPC market structure is initially earning supernormal profits. The initial profit-maximising equilibrium of the firm is at output Q1 and price P1, where MR1 = MC. Supernormal profits is area P1ABC.

The low barriers to entry allows new firms to enter the industry and sell products that are close substitutes to the incumbents’ products. Consumers can now buy from a wider range of products. Assuming total market demand for the product remains unchanged, the entry of new firms causes the demand for each firm’s product to fall. Demand for the firm’s product also becomes more price elastic, since more substitutes are available. 

The demand curve shifts from AR1 to AR2. AR2 is tangential to the AC curve at output Q2, where it makes only normal profits. Output Q2 is the new profit-maximising output level where MR2 = MC. Equilibrium price falls to P2.

Long Run Equilibrium

In the long run diagram for a profit-maximising MPC firm, the total revenue equals total cost, shown by area OPAQ. Hence, profits are zero.