Monopolistic Competition. A monopolistically competitive market has many buyers and sellers, perfect information, heterogeneous output, price-making firms, profit maximizers and low entry/exit barriers.
Assumptions
⦁ 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.
⦁ 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.
⦁ 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.
⦁ 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.
⦁ Firms Maximize Profit at MR = MC.
⦁ 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 MR = MC and produce q* in the long-run. As AR = AC, monopolistically competitive firms earn normal profit in the long-run.
Efficiencies
⦁ Allocatively Inefficient. Monopolistically competitive firms are always (short-run and long-run) allocatively inefficient because they set P > MC, they do not produce what consumers want or the quantities demanded.
⦁ 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.