Revision Notes

Unit 2.
11(4) Market power - Monopolistic competition (HL)
What you should know by the end of this chapter:

• Definition of monopolistic competition
• Assumptions of monopolistic competition
• Product differentiation
• Demand and revenue
• Explanation and diagrams of normal profit,
abnormal profit and losses
• Efficiency in monopolistic competition
• Evaluation of monopolistic competition
The nature of monopolistic competition

Monopolistic competition is a form of imperfect competition. Many markets across the economy
share the characteristics of monopolistic competition such as hairdressers, restaurants, plumbers
and care homes. These markets are made up of a large number of firms accounting for a high
proportion of total market output. The increased realism of the monopolistic competition model
compared to perfect competition allows us to make more accurate predictions about the way
markets of this type behave.
The example we are going to use in this chapter to analyse monopolistic competition is hairdressers.
There are some larger businesses in the market but most hairdressers in an economy are small,
independently owned firms.
Assumptions of the model

Large number of buyers and sellers
The market is made up of a large number of small buyers and sellers in the market. Each firm has a
small proportion of total market sales which means there is a low concentration ratio. This means
each firm has very limited market power which is typical of the hairdressing market.
Barriers to entry
There are no barriers to entry into or exit from the market in monopolistic competition. Similar to
perfect competition there are no costs or restrictions over and above the normal costs of new firms
setting up in the market. There are also no barriers to exit that prevent firms from leaving the
market. Setting up a hairdresser would mean renting a retail space which has to be fitted out with
appropriate equipment and then hiring staff. This would be a relatively straightforward market to
enter because there are no excessive regulations and costs associated with entering the market.
© Alex Smith
InThinking www.thinkib.net/Economics 1
Differentiated products
Each firm in a market sells a product that is similar but
slightly different to the products of other firms in the
market. Hairdressers in a town, for example, offer similar
services but can be differentiated in a number of ways, such
as specialising in men’s or women's hair, the types of cuts
offered and the style and layout of the premises. The
picture shows examples of how different hairdressers can
differentiate their services.
Demand and revenue in monopolistic competition

Demand curve
The differentiated product assumption of monopolistic competition has an important effect on the
demand curve the firm faces in the model. Because each firm sells a product that is different to
others in the market, they face a downward sloping demand curve and firms have some control over
the price they charge. Firms in monopolistic competition are price makers rather than being price
takers as firms are in perfect competition. For example, a hairdresser in a monopolistically
competitive market could increase their price and not see quantity demanded fall to zero because
their differentiated product will enable them to retain some loyal customers. If a hairdresser
increases its price, some customers might stay with a hairdresser because they like the person that
cuts their hair and the way they are looked after in the salon. If a firm in monopolistic competition
reduced its price it will be able to attract some buyers away from other producers in the market.
Elasticity
Because there are many competing firms in the market selling differentiated products it will be
relatively easy for buyers to substitute towards a firm’s product when its price falls and away from a
firm's product when its price rises. This means the demand for the good or service of individual firms
in the market is relative prices elastic. A change in price by a firm in monopolistic competition will
cause a greater proportionate change in the quantity demanded for the good it sells.
© Alex Smith
Revenue
A downward sloping demand curve in monopolistic competition changes the revenue curves the
firm faces. The table below sets out the total revenue, average revenue and marginal revenue for a
firm in a monopolistically competitive market. Because the demand curve is downward sloping the
average revenue and marginal revenue curves are separate and the marginal revenue is twice as
steep as the demand curve and is negative when demand becomes price inelastic. This is shown in
diagram 2.72.
Costs
The short-run cost curves of the firm in monopolistic competition are affected by the law of
diminishing returns as they are in perfect competition. The marginal cost, average cost and average
variable cost curves are always U-shaped.
Profit maximisation
Firms aim to profit maximise in monopolistic competition and they achieve this by producing where
marginal cost equals marginal revenue when marginal cost is rising. They then set their price based
on consumer demand for that level of output. Price, output and profit maximisation are shown in
diagram 2.72.
© Alex Smith
Profits and losses
Normal profits
Normal profit exists in monopolistic

competition when total cost equals total
revenue at the profit maximising output.
In diagram 2.72 this will be where
average total cost equals average
revenue at the profit maximising output:
(AR = ATC) x Q
When firms in the industry are making

normal profits, the market is in
equilibrium which means entrepreneurs
are making enough profit to keep their
business in the market. In the hairdresser
example, the firm is making normal
profit at a price of $40 and an output of 50 haircuts.
Abnormal profit
When firms in the market are earning
abnormal profit total revenue is greater
than total costs and the firm is making
more than the minimum profit required
to keep them in the market. In diagram
2.73 this is where average revenue is
greater than the average total cost at the
profit maximising output.
(AR – ATC) x Q = abnormal profit
In the hairdresser example, the abnormal profit is:
($40 - $32) x 50 = $400
Abnormal profit is a short-run equilibrium situation. In the long run, the abnormal profit attracts
new firms into the market and as the number of firms in the market increases the demand curve for
existing producers in the market decreases (shifts to the left) as new substitutes enter the
market. New firms stop entering the market when the abnormal profit is competed away and all the
firms in the market are earning normal profits. This is shown in the diagram 2.73.
© Alex Smith
Losses
When firms earn losses in monopolistic
competition it means the total cost is
greater than total revenue and firms are
not making the minimum profit required
to keep producing in the market. In
diagram 2.74 this is shown where the
average total cost is greater than average
revenue.
(ATC – AR) x Q = losses
In the hairdresser example the loss is:
($46 - $40) x 50 = $300
Losses are a short-run equilibrium situation. If firms in the market do not earn the minimum profit
needed to keep them in the market (normal profit) they will leave the industry. As firms leave the
market there will be less competition for existing producers and this will cause the demand curves
for these firms to increase (shift to the right) returning the firms to normal profit in the long run.
Efficiency in monopolistic competition

Productive (technical) efficiency
Productive efficiency occurs in
monopolistic competition when all firms
in the market produce at minimum
average total cost where marginal cost
equals average total cost at the profit
maximising output. Unlike perfect
competition, firms in monopolistic
competition do not achieve productive
efficiency because they do not produce
where marginal cost equals average
total cost. This is shown in diagram
2.75.
© Alex Smith
Allocative efficiency
Allocative efficiency is achieved when demand equals supply in the market or where firms set price
equal to marginal cost and the community/social surplus is maximised. Unlike perfect competition
firms in monopolistic competition, profit maximise by charging a price above marginal cost and
producing an output below the allocatively efficient level. This means prices are higher and output
lower than would be the case in perfect competition. This is shown in diagram 2.75.
Evaluation of monopolistic competition

Here are two judgements that can be made about monopolistic competition:
• In reality most markets are made up of businesses of different sizes and cost structures. Even
where there are many small firms in the market large firms are likely to exist and will have more
influence on the market than the smaller businesses.
• Although monopolistic competition is neither allocatively nor productively efficient compared to

perfect competition it does offer the consumer more choice because firms sell a differentiated
product. The homogenous products sold in a perfectly competitive market may have a lower price
compared to monopolistic competition but the goods on offer from different producers would all be
the same. Imagine being faced by a number of hairdressing salons offering exactly the same service!
© Alex Smith

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Unit 2.

11(4) Market power - Monopolistic competition (HL)

What you should know by the end of this chapter:

The nature of monopolistic competition

Assumptions of the model

Demand and revenue in monopolistic competition

Normal profit exists in monopolistic

When firms in the industry are making

(AR – ATC) x Q = abnormal profit

In the hairdresser example, the abnormal profit is:

($40 - $32) x 50 = $400

(ATC – AR) x Q = losses

In the hairdresser example the loss is:

($46 - $40) x 50 = $300

Efficiency in monopolistic competition

Evaluation of monopolistic competition

• Although monopolistic competition is neither allocatively nor productively efficient compared to

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