This document discusses the economic model of monopolistic competition. Key assumptions of this model include: - Firms produce differentiated products and have some degree of monopoly power over their own products but face competition from close substitutes. - The industry contains a large number of small firms relative to the overall market size. - There is free entry into the industry, so abnormal profits will attract new competition over time. In the short run, firms can earn abnormal profits that depend on demand elasticity. In the long run, entry of new firms increases supply and reduces prices until all abnormal profits are eliminated and firms earn only normal profits. The market reaches long-run equilibrium.

1. Models of market structure
Monopolistic competition
© Economics Department, King’s School, Chester

2. Key assumptions
 Each firm in the industry produces a product which is differentiated
from that of others
 branding and advertising exists
 location plays an important part in this product differentiation
 each firm has a degree of monopoly power and faces its own downward
sloping demand curve, but there are many close substitutes
 firms act as price makers and not price makers
 The industry is made up of a large number of buyers and sellers.
 in particular firms are small in comparison to the size of the market
 The actions of one firm do not affect rivals (ie independence)
 There is freedom of entry to the industry
 abnormal profits attract new entrants
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3. Price
Short run equilibrium
MC
P
AC
C
Firms are able to
make abnormal
profits in the short
run. The size of
these profits
depends on the
position of the
demand curve and
its elasticity.
D=AR
Q
Output
MR
© Economics Department, King’s School, Chester

4. Price
Entry of new firms
MC
P
AC
D=AR
Q
Output
MR
© Economics Department, King’s School, Chester

5. Price
Entry of new firms
MC
AC
P
D=AR
Q
The entry of new
firms results in
lower demand for
existing firms.
New firms
continue to enter
until all abnormal
profit is competed
away.
Output
MR
© Economics Department, King’s School, Chester

6. Price
Long run equilibrium
MC
AC
P
D=AR
Q
Long run
equilibrium occurs
when firms earn
normal profit (AR
= AC). This may
be the so-called
‘marginal’ firm in
the industry and
not all. The
marginal firm is
the one having
same costs as
new entrants.
Output
MR
© Economics Department, King’s School, Chester

7. Implications
 Economic efficiency
 Firms do not produce at the bottom of their AC curve
– productive inefficiency
– firms are forced to charge higher prices
– firms have ‘excess capacity’
 Prices are above MC
– allocative inefficiency
 Such inefficiencies may be small since substitutes result in elastic demand
 There is greater product variety than in perfect competition
– product variety is likely to be valued by consumers
– higher prices may simply be the cost of variety
© Economics Department, King’s School, Chester

8. Implications
 Non-price competition
 Since entry reduces demand and price, firms can be expected to use nonprice methods of competition
– Product development
– Service quality
– Location
– Opening times
– Frequency of service
– Advertising
 Non-price competition attempts to
– Reduce the elasticity of demand
– Create brand loyalty so that new entry does not reduce demand
© Economics Department, King’s School, Chester

9. Independent learning tasks
 Can you give examples of monopolistically competitive markets in transport?
 Use the Economist links below to investigate the
market for taxi services
 http://www.economist.com/world/europe/displayStory.cf
m?story_id=1383147
 http://www.economist.com/world/europe/displayStory.cf
m?Story_id=S%27%29H%2C%2FQQ
%23%27%23%40%21%28%0A
 http://www.economist.com/world/europe/displayStory.cf
m?Story_id=S%26%28H%24%25PQ%5B%2B%0A
 To what extent is the market for taxi services
monopolistically competitive?
 How does the existence of black cabs and mini cabs
affect the market structure for taxi services?
 Comment on the case for deregulation of taxi services
© Economics Department, King’s School, Chester

10. Independent learning tasks
 Can you give examples of monopolistically competitive markets in transport?
 Use the Economist links below to investigate the
market for taxi services
 http://www.economist.com/world/europe/displayStory.cf
m?story_id=1383147
 http://www.economist.com/world/europe/displayStory.cf
m?Story_id=S%27%29H%2C%2FQQ
%23%27%23%40%21%28%0A
 http://www.economist.com/world/europe/displayStory.cf
m?Story_id=S%26%28H%24%25PQ%5B%2B%0A
 To what extent is the market for taxi services
monopolistically competitive?
 How does the existence of black cabs and mini cabs
affect the market structure for taxi services?
 Comment on the case for deregulation of taxi services
© Economics Department, King’s School, Chester