1

13. Monopolistic Competition

Introduction
The name monopolistic competition is applied to a market that has a lot of
competition from other firms but is different from perfect competition in
that firms can gain a small amount of market power. This type of market has
the following features.

1. Structure
There are a large number of firms in the industry.
Firms are generally small with insignificant market share. Concentration
ratios for these industries are low. Similar to perfect competition.
Some barriers to entry exist but they are not insurmountable.
Product differentiation is extensive and may represent a considerable but
not insurmountable barrier to entry.
Firms are generally small, economies of scale are insignificant and firms
experience similar production costs.
The products of other firms represent a substitute for the firms product.
This means that the firms demand curve is more elastic than for firms in
monopoly. The degree of price elasticity of demand faced by the firm
will depend on the number of firms in the industry and the success of the
firms product differentiation.

2. Conduct
All firms engage in product differentiation. Product differentiation is an
attempt to make the firms products different from those of its
competitors.
Product differentiation, advertising and other types of non-price
competition are important to firms in this type of market. Non-price
competition includes all methods of competing with other firms that does
not involve price.
Price changes can cause consumers to switch to other brands and so
prices are generally set competitively.
Price fixing is impossible because there are too many firms and pricing
and output conduct of a firm has minimal impact on other firms as a
result of the fact that consumers are ready to switch brands.



2

Forms of non-price competition include:
Advertising: Advertising is the use of promotion and commercials to
establish that one brand is better than rival brands. Advertising can be
either persuasive or informative.
Packing: Packaging refers to how the product is presented to the
consumer. If expensive packaging is used consumers may be prepared to
pay more for the brand.
Quality: By improving the quality of a product through technology and
innovation consumers may be prepared to insist on a particular brand.
Such a brand may prove more reliable or longer lasting.
Location: Retail outlets are often examples of monopolistic competition.
Location is an important factor for these businesses because those with
better locations or passing traffic often are more profitable than other
rival business with poor locations.
Warranties: A warranty is a guarantee that the product will last a certain
period of time. Manufacturers may offer to replace or fix the product
during this period. Consumers will naturally prefer those products with a
longer warranty.

If a firm is successful in differentiating its product it will:
Increase the demand for its product, shifting the demand curve to the
right. (Consumers are convinced that this brand is better and are prepared
to pay more for it).
Achieve consumer loyalty or brand allegiance, reducing the price
elasticity of demand for its product. (Consumers are loyal to the product
and are prepared to pay higher prices. This has the effect of making the
demand for this brand more price inelastic).

Monopolistic versus Oligopolistic markets:
The distinction between monopolistic and oligopolistic markets can be
blurred and it is often difficult to decide whether a market is one or the
other.

Conduct of the monopolistically competitive firm:
There is little variation in the pricing policies of rival firms:
Most of their behaviour is centered on non-price competition. For
example:
better quality driveway service at petrol stations
3
home delivery of groceries
attractive packaging
location near free parking
Pharmacies supplying two photo prints for the price of one.

This non-price competition is designed to increase demand for the firms
products and by creating some brand loyalty to make consumer demand for
the product more inelastic. (PED falls indicating that consumers are prepared
to pay higher prices for the product and are less price sensitive.)

To some extent the monopolistically competitive firm can behave as a Price
Maker. If it can successfully differentiate its product then it can charge a
higher price than its competitors. It is able to make supernormal profits in
the short run.

3. Performance
Entry barriers are ineffective in the long run and new firms enter the
market attracted by supernormal profits.
The new firms take some of the market share of existing firms and the
demand curve falls for all firms just like in perfect competition to the
point where all firms make a normal profit.
The firms demand curve falls to the normal profit position at a tangent to
the average total cost curve. The demand curve for the firm also becomes
more elastic as the brand loyalty breaks down. This means that the point
of tangency comes closer to the technical optimum.
In the long run firms in monopolistic competition fail to achieve
productive efficiency. They fail to achieve the least cost level of output at
the technical optimum. In reality these industries are overcrowded with a
large number of firms each of which is under-utilized and operating short
of optimum capacity.
Allocative efficiency is not achieved because price exceeds marginal cost
in the long run diagram. Consumers are often penalised with higher than
competitive prices. In addition the cost of advertising is usually high in
these markets. Advertising increases the cost of production and this is
passed on to the consumer in the form of higher prices.
As a result of the emphasis on non-price competition firms will attempt
to gain a technical or product edge on competitors. This means that firms
in monopolistic competition achieve dynamic efficiency. However like in
perfect competition firms are small and may not be able to afford large
4
expenditure on research & development. This may limit the amount of
dynamic efficiency achieved.

In the long run rival firms will copy the successful product differentiation
of the firm and its ability to earn supernormal profits will be lost.
In the long run the monopolistic competitor will enjoy only a normal
profit.
The firms demand curve will flatten and move to the left. This is
because new firms will enter the industry and be attracted by any
supernormal profits. The output of these firms will create close
substitutes for existing firms who will lose customers and find that their
product is increasingly price elastic. Consumers will switch to rival
brands if the firm increases price.
There is significant incentive for the firm to innovate and undertake
research & development to maintain brand loyalty and pricing power.
It is possible that some firms will be able to maintain a slight edge in the
long run as a result of product differentiation which is difficult to
duplicate.
Firms in monopolistic competition are more dynamically efficient than
firms in perfect competition.


Monopolistic Competition Supernormal Profit

Output ATC MC D = AR MR
1 260 90 180 110
2 200 80 170 100
3 150 70 160 88
4 115 65 150 75
5 96 65 140 65
6 84 70 130 50
7 80 80 120 40
8 84 105 110 28
9 96 140 100
10 115 185 90
11 150 240 80
12 200 310 70
13 260 350 60

5
Monopolistic Competition -
Supernormal Profit
0
50
100
150
200
250
300
350
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Output
R
e
v
e
n
u
e

&

C
o
s
t


The firm produces at the profit maximising level of output where MR = MC.
This occurs at 5 units of output. At this level of output the firm is making a
supernormal profit because AR > AC. From the above table at 5 units of
output AR = 140 and AC = 96. This means that the firms profit margin is
44. If the firm produces 5 units of output, it will earn supernormal profit of 5
x 44 = 220. This only happens to firms in the short run in this market.

Monopolistic Competition Normal Profit

Output ATC MC D = AR MR
1 260 90 165 125
2 200 80 145 110
3 150 70 128 95
4 115 65 110 80
5 96 65 96 65
6 84 70 80 50
7 80 80 65 35
8 84 105 50 20
9 96 140 35
10 115 185
11 150 240
12 200 310
13 260 350

6
Monopolistic Competition - Normal
Profit
0
50
100
150
200
250
300
350
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Output
R
e
v
e
n
u
e

&

C
o
s
t


The firm continues to produce at the profit maximising level of output at 5
units of output where MC = MR. Demand has fallen such that it is at a
tangent to ATC at this level of output. This means that AR = AC at this level
of output. From the above table we can see that both AR and AC are equal to
96 at 5 units of output. This means that the firm is making a normal profit.
This is characteristically what happens to firms in the long run in this
market.

4. Government Policies for Monopolistic Competition

Competition Policy
Firms in monopolistic competition are actively trying to gain an advantage
over their competitors. This may mean that unfair business practices are
used. The Trade Practices Act may be relevant to firms in these types of
industries. In particular the following concepts could be relevant to firms in
this type of market.
False advertising = it is illegal for firms to make false claims in advertising.
Unconscionable conduct = it is illegal for firms to act unfairly.
Misleading & deceptive conduct = could apply to any action that attempted
to take advantage of consumers.

7
Consumer Protection
Consumers can be disadvantaged in these industries. There are numerous
and often contradictory product claims which can easily confuse consumers.
Measures to protect consumers like product standards, cooling off periods
for contracts and industry codes of conduct are important protections in
these types of markets. Some problems encountered by consumers in these
markets could include: pyramid selling, taking deposits without the intension
of supplying goods, failing to adhere to product standards, bait & switch,
refusal to honor warranties and failure to supply goods of merchantable
quality or goods that are fit for purpose. These problems are dealt with by
the Fair Trading Act and the Sale of Goods Act.

Licensing
Many small firms in these types of markets require a license to operate.
Tradesmen need a license to show that they have the required knowledge
and training. Small shops selling liquor, tobacco, milk etc require a license
to operate. A license provides a method of regulation and ensures that any
license conditions are complied with. A shop selling food has to meet certain
health standards. A liquor shop is unable to sell alcohol to children. These
license conditions are a method of regulation and offer some protection to
consumers.

Industry Assistance
Firms in monopolistic competition are small and can benefit from assistance.
A good example of this type of market is clothing textiles and footwear.
Firms in this industry are often very small, entry barriers are low and they
have all the characteristics of firms in monopolistic competition. There are
several reasons for why clothing manufacturers have been given assistance.
This industry is an important source of employment. Australian clothing
manufacturers have to compete with cheap imported products from China,
Thailand and Indonesia. Countries overseas use child labour and pay very
low wages compared to minimum wages in Australia. Australian
governments have for many years supported this industry with a variety of
protection measures including tariffs, quotas and subsidies. Without this
assistance many firms in this industry would have been unable to compete.
This assistance has recently been reviewed and many tariffs have been
reduced. This has caused industry restructuring see media article.

8
Exam Questions
Short Answer Questions
1. In the long run in monopolistic competition firms make:
a) Supernormal profit.
b) Normal profit.
c) Breakeven.
d) Both (b) and (c) above.

2. The following are examples of product differentiation except:
a) Brand names.
b) Pricing.
c) Location.
d) Clearance sales.

3. All of the following are structural features of monopolistic competition
except:
a) Large number of buyers and sellers.
b) Low barriers to entry.
c) Homogenous products.
d) Product differentiation.

4. In the long run new firms enter a monopolistically competitive market
because:
a) They are attracted by supernormal profits.
b) Entry barriers are low.
c) It is easy to copy the advertising and marketing of other firms.
d) All of the above.

5. A successful advertising campaign in a monopolistically competitive
market will:
a) Create supernormal profits.
b) Increase brand loyalty.
c) Increase the firms cost of production.
d) All of the above.
9
Short Answer
1. Why was the name monopolistic competition invented?
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________

2. What is the market structure for monopolistic competition?
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________

3. Why do firms in monopolistic competition use product
differentiation?
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________

4. How do firms differentiate their products?
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
10
5. Why do firms in monopolistic competition make a normal profit in the
long run?
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________

6. Why is productive efficiency not achieved by firms in monopolistic
competition?
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________

7. Why is allocative efficiency not achieved by firms in monopolistic
competition?
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
11
Extended Response
Compare and contrast perfect competition with monopolistic
competition. Use diagrams where appropriate. What government
policies can be used to improve the conduct of firms in monopolistic
competition?

Rule 1: Define the terms in the question: Perfect competition, monopolistic
competition & relevant features of each, government policies.
Rule 2: Identify & define related concepts: Homogenous products,
differentiated products, normal profit in the long run, tariffs, and subsidies.
Rule 3: Link introduced terms to the question: Firms in both markets make a
normal profit in the long run.
Rule 5: Draw relevant diagrams: PC & MC
Rule 6: Text reference to diagram in your answer: A normal profit in
monopolistic competition is shown in the following diagram.
Rule 7: Use examples to communicate additional meaning: Product
differentiation like brand names are used in MC: for example coca-cola.
Rule 4: Draw logical conclusions: The main difference between PC and MC
is that the product is differentiated in MC. Consumers need to be protected
in these industries.