Monopolistically Competitive Firms

What do a restaurant on the street and a maker of packaged snacks have in common?

One thing that they have in common is that they both are examples of monopolistically competitive firms. Actually, many firms that we interact with in our daily life operate in monopolistically competitive markets. Does this sound intriguing? Do you want to learn all about it now? Let's go at it!

Characteristics of a Monopolistically Competitive Firm

What are the characteristics of a monopolistically competitive firm? You may have guessed it - such a firm has the characteristics of both a monopolist and a firm in perfect competition.

How is a monopolistically competitive firm like a monopolist? This comes from the fact that in monopolistic competition, each firm's product is a little different from the products of other firms. Since the products are not exactly the same, each firm has some power in setting the price for its own product. In more economics-sounding terms, each firm is not a price-taker.

At the same time, a monopolistically competitive firm differs from a monopolist in two crucial ways. One, there are many sellers in a monopolistically competitive market. Second, there are no barriers to entry and exit in monopolistic competition, and firms can enter and exit the market as they like. These two aspects make it similar to a firm in perfect competition.

To sum up, the characteristics of a monopolistically competitive firm are:

1. It sells a differentiated product from similar products of other firms, and it is not a price-taker;

2. there are many sellers offering similar products in the market;

3. it faces no barriers to entry and exit.

Monopolistically Competitive Firms Examples

There are many examples of monopolistically competitive firms. Actually, most of the markets that we face in real life are monopolistically competitive markets. There are many sellers offering differentiated products, and they are free to enter or exit the market.

Another example of monopolistically competitive firms is the makers of packaged snack items that we find in every supermarket.

The Demand Curve Faced by a Monopolistically Competitive Firm

What is the demand curve faced by a monopolistically competitive firm like?

Because firms in a monopolistically competitive market sell differentiated products, each firm has some market power unlike in the case of perfect competition. Therefore, a monopolistically competitive firm faces a downward-sloping demand curve. This is also the case in a monopoly. In contrast, firms in a perfectly competitive market face a flat demand curve as they are price-takers.

In a monopolistically competitive market, firms can freely enter and exit the market. When a new firm enters the market, some customers will decide to switch to the new firm. This reduces the market size for the existing firms, shifting the demand curves for their products to the left. Similarly, when a firm decides to exit the market, its customers will switch to the remaining firms. This expands the market size for them, shifting their demand curves to the right.

A Monopolistically Competitive Firm's Marginal Revenue Curve

What about a monopolistically competitive firm's marginal revenue curve then?

You might have guessed it. It's just like in a monopoly, the firm faces a marginal revenue curve that is below the demand curve, shown in Figure 1 below. The logic is the same. The firm has market power over its product, and it faces a downward-sloping demand curve. In order to sell more units, it has to lower the price of all units. The firm will have to lose some revenue on the units that it was already able to sell previously at a higher price. This is why the marginal revenue of selling one more unit of the product is lower than the price that it charges.

Fig. 1 - A monopolistically competitive firm's demand and marginal revenue curves

So how does a monopolistically competitive firm maximize profit? What quantity will the firm produce and what price will it charge? This is also like the case with monopoly. The firm will produce until the point where marginal revenue is equal to marginal cost, Q_MC. It then charges the corresponding price at this quantity, P_MC, by tracing to the demand curve. How much profit (or loss) the firm makes in the short run depends on where the average total costs (ATC) curve lies. In Figure 1, the firm is making a good profit because the ATC curve is quite a bit lower than the demand curve at the profit-maximizing quantity Q_MC. The red-shaded area is the firm's profit in the short run.

Monopolistically Competitive Firm in Long-run Equilibrium

Will a monopolistically competitive firm be able to make any profit in the long-run equilibrium?

To answer this question, let's first consider what happens in the short run. Whether firms in the monopolistically competitive market can actually make a profit in the short run will affect the entry and exit decisions of the firms.

If the average total costs (ATC) curve is below the demand curve, the firm receives more revenue than cost, and it is turning a profit. Other firms see that there is profit to make and will decide to enter the market. New firms' entry into the market shrinks the market size for the existing firm because some of its customers will turn to the new firms. This shifts the demand curve to the left. New firms will continue to enter the market until the demand curve just touches the ATC curve; in other words, the demand curve is tangent to the ATC curve.

A similar process will happen if the ATC curve is above the demand curve initially. When this is the case, the firm is making a loss. Some firms will decide to exit the market, shifting the demand curve to the right for the remaining firms. Firms will continue to exit the market until the demand curve is tangent to the ATC curve.

When we have the demand curve being tangent to the ATC curve, no firms will have the incentive to enter or leave the market. Therefore, we have the long-run equilibrium for the monopolistically competitive market. This is shown in Figure 2 below.

Fig. 2 - Long-run equilibrium for a monopolistically competitive firm

We can see that a monopolistically competitive firm will make zero profit in the long run, just like a perfectly competitive firm would. But there are still some important differences between them. A monopolistically competitive firm charges a price above its marginal cost while a perfectly competitive firm charges a price equal to the marginal cost. The difference between the price and the marginal cost of producing the product is the markup.

Additionally, we can see from the Figure that, the monopolistically competitive firm does not produce at the point that minimizes its average total costs, called the efficient scale. Because the firm produces at a quantity that is below the efficient scale, we say that the monopolistically competitive firm has excess capacity.