Four characteristics of monopolistic competition:

·        There are many buyers and sellers in the market place, none of whom are large enough to influence the price.  Sellers are described as being price takers.

·        There is freedom of entry and exit into the market, i.e., barriers to entry are low. Firms must be able to establish themselves quickly in the marketplace.

·        Buyers and sellers have perfect knowledge, economic agents are fully informed of prices and output in the industry.

·        Firms produce a non-homogeneous (differentiated) product.

It can be seen that the characteristics are the as perfect competition, except monopolistic firms produce a non-homogeneous product.

Demand curve

As firms produce a differentiated product, they will have a certain amount of market power due to brand loyalty. Firms are therefore not price takers, as they can raise prices without losing all of their customers. The demand curve will be downward sloping, but relatively elastic due to the number of close substitutes.

Short run equilibrium

It is possible that a firm operating in monopolistic competition could earn abnormal profits, normal profits or make a loss.

·        Abnormal profits (AR>AC)

·        Normal profits (AR=AC)

·        Losses (AR less than AC).

Long run equilibrium

The absence of barriers to entry allows firms to enter the industry, this will occur if abnormal profits are being earned. The entry of new firms will shift the demand curve for any particular firm to the left, as consumers demand moves from one firm to another. The demand curve will continue to shift to the left until it is tangential to the average cost curve (AR=AC), where normal profits are earned and there is no incentive for further firms to enter the industry.

This is a rather complicated diagram, I have found the following is the best way of drawing it:

·        Draw a relatively inelastic demand / average revenue curve and marginal revenue curve (remember the demand curve should be elastic).

·        Draw the average cost curve, with its point of tangency towards the top of the average revenue curve.

·        Label the price and quantity at the point of tangency.

• Now draw the marginal cost curve, it is essential that it cuts the marginal revenue at the quantity label in the previous step. The marginal cost curve must also intersect the average cost at its minimum.

Internet links
Monopolistic Competition PowerPoint Model
Monopolistic Competition PowerPoint Presentation
Imperfect competition
Monopolistic Competition Worksheet