A) Allocatively Inefficient.
Monopolistically competitive firms are always (short-run and long-run) allocatively inefficient because they set , they do not produce what consumers want or the quantities demanded.
B) Productively Inefficient.
Monopolistically competitive firms are always (short-run and long-run) productively inefficient because they never produce at the bottom of their AC curve. Monopolistic competition combines the price-making of monopoly with the many firms of perfect competition. Monopolistically competitive firms earn normal profit and are allocatively and productively inefficient in both the short-run and long-run. Monopolistic competition is very common in reality, some examples include: restaurants, salons, clothes, hotels, toothpaste, fast-food shops and newsagents.
Assumptions:
1) Many Buyers and Sellers.
Many sellers means that each firm has a small market share. Many buyers means no buyer has any monopsony power to affect prices.
2) Imperfect Information.
Information is imperfect but near perfect. Almost all information is available at zero cost. Most information including that of firms’ prices and products are known.
3) Heterogeneous/Differentiated Goods.
Firms produce heterogeneous goods, goods slightly different from each other, so goods are close substitutes. Goods may be different because of some physical differences like look, taste or feel. Advertising could also be used to create a perception of differentiation even if goods share basically the same physical characteristics. Advertising creates a brand image and brand loyalty, it makes demand more inelastic because consumers become attached to buying a good from a certain firm, they become less sensitive to price changes for that particular firm’s good.
4) Firms are Price-Makers.
Because firms produce heterogeneous goods, each firm has some degree of monopoly power so firms are price-makers. A firm can raise its price without losing all of its consumers. So each firm faces downward sloping AR and MR curves. Although, these curves are very elastic because goods are close substitutes.
A firm’s demand curve depends on the number of rival firms in the market. As the number of firms in the market rises, each firm’s demand curve shifts left because consumers become more spread out over each firm (buy less from each particular firm).
5) Firms Maximize Profit at .
6) Low Entry or Exit Barriers.
New firms can easily enter the industry at any time and incumbent firms can easily leave the industry at any time.
Long-Run Equilibrium Because monopolistically competitive firms maximize profit they set and produce q* in the long-run. As , and monopolistically competitive firms earn normal profit in the long-run.
A) Allocatively Inefficient.
Monopolistically competitive firms are always (short-run and long-run) allocatively inefficient because they set , they do not produce what consumers want or the quantities demanded.
B) Productively Inefficient.
Monopolistically competitive firms are always (short-run and long-run) productively inefficient because they never produce at the bottom of their AC curve.
Short-Run Equilibrium Assume an increase in industry demand occurs and each firms’ AR and MR curves shift rightwards.
As the MR and AR curves shift rightwards, a higher market price is received and more is produced. At , so firms are now making super-normal profit.
Because of perfect information and no entry barriers, super-normal profit acts as a signal attracting new firms to enter the industry. New firms take away some of the existing firms’ consumers until and both shift back to their long-run equilibrium levels. Super-normal profit is competed away and normal profit is earned again.
An Example of Monopolistic Competition: Restaurants Restaurants are a good example of monopolistic competition.
