Most goods and services today are produced in markets where the amount of competition is more than under a monopoly and less than under a perfect competition. This type of market is known as monopolistic competition.
Perfect competition assumes that there are many small firms and all goods are homogenous, and in monopoly it is assumed there is only one supplier. However in reality neither of these conditions is exactly met and therefore often industries fall in between these two extremes. In most industries some competition exists because there are at least two firms, but competition is imperfect because firms sell products which are not homogenous.
When there are lots of similar goods with slight differences between them like soaps and detergents, we say there is product differentiation.
The assumptions made for monopolistic competition are almost the same as perfect competition minus one important assumption. Goods don’t have to be homogenous. The assumptions made are:
1. There are a large number of small firms
2. There are low barriers to entry or exit.
3. Firms produce similar but differentiated products.
What is meant here is that the products are similar but differentiated in terms of packaging, colour, design, specification, marketing or price from rival products.
The downward sloping demand curve
Firms producing a product which is slightly different from their rivals will have a certain amount of market power. They will, for instance, be able to raise price without losing all of their customers to those firms who have maintained stable prices. Therefore the firm’s demand curve is downward sloping.
It is not a price-taker like a firm operating in a perfectly competitive environment. Yet because there are a large number of firms producing close substitutes, its market power is likely to be relatively weak.
If one examines the case of Chinese restaurants operating in Chinatown in London, because the consumer has a great deal of choice the prices which are set by the individual restaurants will be similar. If one restaurant were to drastically raise prices then it is likely they would lose many customers unless they were able to brand their product in such a way as to differentiate it from the rivals.
The firm will produce where MC=MR so as to profit maximise. In Figure 1, this means that it will produce at an output level of Q1. It will charge a price based on its demand or average revenue curve, in this case P1.
In the long-run the firm will not be able to obtain super-normal profits, because new firms will enter the industry if they see profits to be made exploiting the lack of barriers to entry. The entry of new firms will increase supply, shifting the average revenue curve downwards to the point where average revenue is just equal to average cost, as in Figure 1.
If the firm were making a loss, firms would leave the industry, reducing supply and shifting the AR curve upwards again to a point where average revenue is equal to average cost. Therefore in the long-run a monopolistically competitive firm can make neither super-normal profits nor losses.