• The characteristics of?monopolistic competition?are as follows

1. There are a large number of small firms:?each one is relatively small and can act independently of the market
2. There is low?barriers to entry?& exit from the industry:?firms can start-up or leave the industry with relative ease which increases the level of competition
3. The products are slightly?differentiated: this structure exists as consumers have different desires e.g. two nail bars differentiate their product through express or pampered service. Some consumers want an express service & others want to linger. A relatively homogenous product has now been differentiated
4. There is a?low degree of market power?& some price setting ability

• In order to?maximise profit, firms in monopolistic competition produce up to the level of output where?marginal cost?=?marginal revenue?(MC=MR)
• The firm does have some?market power?and is able to influence the price & quantity
  • The firm is a?price maker
    • This is due to the fact that they have a?differentiated product?that is desirable by certain consumers
• The firm can make?supernormal profit?in the short-run
• In the long-run, the firm will return to a long-run equilibrium position in which they make?normal profit
  • This is due to inability to defend against?new competitors who enter the market?& copy the products of existing sellers
  • Firms will attempt to find new ways to?differentiate their product?to prolong the period of supernormal profit e.g. a barber shop may add in a pool table & beer fridge for their customers to enjoy thus making them different from the competition (for a period of time)

Short-run Profit Maximisation

• Firms in?monopolistic competition?are able to make?supernormal profit?in the?short-run
• The?AR curve?is the?demand curve?of the firm & it is downward sloping
  • ?The firm has some?market power?due to the level of?product differentiation?that exists
    • To sell an additional unit of output, the firm will have to decrease its price
    • The?marginal revenue (MR)?curve will fall twice as quickly as the AR

A diagram illustrating a monopolistically competitive firm making supernormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q1)

Diagram Analysis

• The firm produces at the?profit maximisation level of output?where?MC = MR (Q1)
  • At this level the AR (P1) > AC (C1)
  • The firm is making supernormal profit

Short-run Losses

• Firms in?monopolistic competition?are able to make?losses?in the?short-run

A diagram illustrating a monopolistically competitive firm making losses in the short-run as the AR (PE?) <? AC at the profit maximisation level of output (QE)

Diagram Analysis

• The firm produces at the?profit maximisation level of output?where?MC = MR (QE)
  • At this level of output, the?AR (PE) < AC (C1)
  • The firm's loss is

Moving From Short-run Profit/Loss to the Long-run Equilibrium

From Supernormal to Normal Profit

• If firms in?monopolistic competition?make?supernormal profit?in the?short-run,?new entrants are attracted to the industry & the number of sellers increases
  • They are?incentivised?by the opportunity to make supernormal profit
  • There are low?barriers to entry
    • It is easy to join the industry
• Supernormal profit will be eroded & the firm will return to the long-run equilibrium position of making normal profit

From Losses to Normal Profit

• If firms in?monopolistic competition?make losses?in the?short-run,?some will shut down
  • The?shut down rule?will determine which firms shut down
  • There are low?barriers to exit, so it is easy to leave the industry
• For the remaining firms, losses will be?eliminated?& the firm will return to the?long-run equilibrium?position of making?normal profit

A diagram illustrating the long-run equilibrium position for a monopolistically competitive firm?which is making normal profit. AR (P1) = AC at the profit maximisation level of output (Q1)

Diagram Analysis

• The firm is initially producing at the?profit maximisation level of output?where?MC=MR (Q1)
• At this level of output P1 = AC & the firm is making normal profit
• In the long-run,?firms in?monopolistic competition?always make?normal profit
  • Firms making a?loss?leave the industry
  • Firms making?supernormal profit?see it slowly?eradicated?as new firms join the industry

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