Monopolistic Competition

1. Because each product is differentiated rather than identical, the firm can raise price a little without losing all its customers, so its demand curve slopes downward.
   1. With many close substitutes available, that demand curve is relatively price elastic.
2. Firms compete mainly through non-price competition such as branding, quality and design rather than by undercutting each other.
3. It differs from perfect competition in that products are differentiated not homogeneous, and from oligopoly in that there are many firms with no interdependence between them.
   1. Independent coffee shops and local hairdressers each build a slightly different appeal, so each keeps some loyal custom.

Short-run equilibrium

$$MC=MR$$

1. The firm maximises profit where MC = MR, reading output down from that intersection and price up to the AR curve.
   1. On the diagram, output is on the horizontal axis and price and cost on the vertical axis, with the downward-sloping AR curve lying above the MR curve.
2. In the short run the firm earns supernormal profit when AR > AC, shown by the rectangle between AR and AC at the profit-maximising output.
3. If demand is weak it can instead make a loss, with AC lying above AR.

Long-run equilibrium

$$AR=AC$$

1. Low barriers mean short-run supernormal profit attracts new entrants, and as they arrive each existing firm loses custom, so its AR curve shifts to the left.
2. Entry continues until only normal profit remains, where the AR curve is just tangent to the AC curve (AR = AC).
   1. Because AR slopes downward, this tangency can only occur on the falling part of AC, to the left of its lowest point.
3. If firms were instead making losses, some would exit until the survivors returned to normal profit.

Efficiency in monopolistic competition

$$P>MC$$

1. In long-run equilibrium price exceeds marginal cost (P > MC), so consumers value extra units by more than they cost and the firm is allocatively inefficient.
2. Because the tangency sits to the left of the lowest point of AC, output is below the least-cost level, so the firm is productively inefficient and carries excess capacity.
3. In return, product differentiation gives consumers greater choice and variety, so the static inefficiency has to be weighed against that gain.

Is monopolistic competition good for consumers?

1. It holds in consumers' favour in some ways: differentiation gives real choice and variety, and low barriers keep long-run profit down to normal, which limits how high prices can go.
2. But it is statically inefficient, because P > MC signals a welfare loss and excess capacity means goods are produced above minimum average cost, so consumers pay more than in perfect competition.
3. And much of the non-price competition, such as heavy advertising and packaging, can be wasteful and may persuade rather than genuinely inform.
4. On balance it depends on whether consumers value the extra variety more than the higher price, and on how genuine the product differences really are.