Monopolistic competition is a market structure with many small firms that produce differentiated products. While firms have some control over prices, products are still close substitutes. Firms rely on non-price competition like advertising to differentiate themselves. In the long run, firms will earn zero economic profits as entry and exit causes demand to equal average cost. Monopolistic competition results in some inefficiency but provides greater variety compared to perfect competition.

1. CHAPTER 6:
MONOPOLISTIC COMPETITION
LEARNING OBJECTIVE
The purpose of this topic is to look at a very common form of
market where firms are numerous but have some monopoly power.
The characteristics of the market are first stated. The short
and long run equilibrium is shown. The economic effect of this
market is derived. Because of the importance of nonprice action
in this market, advertising is given special attention.
MONOPOLISTIC COMPETITION
Monopolistic competition is a type of market characterized by
- a large number of firms,
- products which are differentiated and not seen as perfect
substitutes by consumers,
- some ability of sellers to set prices as they wish,
- free entry to and exit from the market,
- heavy reliance on nonprice actions to differentiate one's
product.
The monopolistic competition form of market is extremely common.
Almost all retail operations are in this form of market. Small
businesses in all sectors fall in this category. Starting a
business is relatively easily, but staying in business is not:
that requires an ability to convince customers that the product
is different and better than that of competitors.
MONOPOLISTIC COMPETITION NUMBER OF FIRMS
The large number of firms in monopolistic competition implies
that the firms are small in comparison to the entire market.
Although they have some power over price (to the extent that
their products are differentiated), they do not have sufficient
power to retaliate if another firm changes its price. This is
the major distinction between this market form and oligopoly.
MONOPOLISTIC COMPETITION DIFFERENTIATED PRODUCT
The differentiated product sold by a firm in monopolistic
competition has some features that makes a customer prefer it
over the available similar products of other firms. The features
may be physical or created by advertising. The power of any firm
over price stems from this very fact that products are not perfect
substitutes. Nonprice actions are necessary to make the products
differentiated.
MONOPOLISTIC COMPETITION ENTRY TO MARKET
No barriers to entry or exit exist in monopolistic competition.
However, the need to make one's product differentiated may
require nonprice action, which, if unsuccessful, would drive
the firm out of the market.
MONOPOLISTIC COMPETITION DEMAND
The demand of a firm in monopolistic competition is downsloping

2. because of the preference of customers for the features of
the differentiated product. However, because there are many
close (if not perfect) substitutes readily available, the demand
is highly elastic. Graphically, this means that the demand in
monopolistic competition is flatter than in monopoly.
The demand of a restaurant is likely to be very elastic because
there are many other food outlets available to customers. But
the demand is not perfectly elastic (i.e. horizontal) as in the
case of perfect competition because, each restaurant has
something to offer other restaurants do not: for instance,
convenience, location, elaborate menu, or just atmosphere.
MONOPOLISTIC COMPETITION PROFIT
The profit of a firm in monopolistic competition is determined
in the same fashion as in any other type of market by finding the
optimum quantity where marginal revenue intersects marginal
cost. This optimum level of output, in turn, determines the
price charged (on the demand curve) and average unit cost (on
the average total cost curve). The profit is the excess of
total revenue area over total cost area.
A restaurant should accept customers as long as the additional
or marginal revenue exceeds the additional or marginal cost of
the last meal served. This seems to be apparent in the
reservation process which limits the number of patrons. Without
reservations, the restaurant would either have to serve customers
in overcrowded conditions or make them wait on line.
MONOPOLISTIC COMPETITION LONG RUN EQUILIBRIUM
The long run equilibrium of a firm in monopolistic competition
is where demand is tangent to the average total cost curve.
There is no profit. Should there be a profit (if demand is
above the average total cost curve), firms would enter the
market and drive the demand down. And should there be a loss
(when demand is below average total cost), firms would leave
the market and push demand up. Firms may, however, retain some
profits by using more nonprice action.
All successful restaurants have scores of imitators. Several
chains have attempted to duplicate McDonald, and siphoned some
of its customers and profits. But, McDonald has fought back with
extensive advertising.
MONOPOLISTIC COMPETITION ECONOMIC EFFECT
The economic effect of monopolistic competition is an overall
undesirable loss of allocative and productive efficiency: the
customer pays more and is able to buy less than in perfect
competition. However, the effect is not as serious as in
monopoly and the differentiated products provide a much sought
diversity. Nevertheless, some waste is present in excess
capacity and in use of nonprice competition.

3. Generic product markets approach perfect competition because
they are standardized. Brand name products of the same type
(for instance, cookies) are in monopolistic competition because
they are not the same uniform item, but somewhat different.
Customers have to pay a higher price for brand name products
(such as Nabisco or Keebler), but they do not seem to mind too
much.
MONOPOLISTIC COMPETITION NONPRICE ACTION
Nonprice action of firms in monopolistic competition consists
primarily in either
- product development, or
- advertising.
Product development is sometimes only cosmetic to give the
illusion of novelty. Another danger stems from excessive
diversity which may confuse consumers.
Brand name producers have a variety of means to make their
products special to customers. Most important is advertisement
which generic item producers would obviously not use.
ADVERTISING - ARGUMENTS IN FAVOR
Some of the arguments in favor of advertising are
- advertising is informative,
- advertising increases sales and permits economies of scale,
- advertising increases sales and contributes to economic
growth,
- advertising supports the media,
- advertising increases competition and lowers prices.
New product advertisement is essential: think of a major artistic
event that interested viewers would fail to see because it has
not been announced widely enough. But, most of the advertisement
(on television for instance) is for existing, well-established
products such as soft drinks or other consumer products; that
advertisement seeks only to sway customers away from competitors.
ADVERTISING - ARGUMENTS AGAINST
Some of the arguments against advertising are
- advertising is not informative but competitive,
- the economies of scale are illusory,
- advertising raises the cost curve,
- advertisers may use their influence to bias the media,
- advertising is used as an entry barrier, and
- advertising is not a productive activity.