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imperfect marketa type of MARKET STRUCTURE. A monopolistically competitive market is one that is characterized by:
- many firms and buyers: that is, the market comprises a large number of independently acting firms and buyers.
- differentiated products : that is, the products offered by competing firms are differentiated from each other in one or more respects. These differences may be of a physical nature, involving functional features, or may be purely ‘imaginary’ in the sense that artificial differences are created through ADVERTISING and SALES PROMOTION (see PRODUCT DIFFERENTIATION).
- free market entry and exit: that is, there are no BARRIERS TO ENTRY preventing new firms entering the market or obstacles in the way of existing firms leaving the market. (No allowance is made in the ‘theory’ of monopolistic competition for the fact that product differentiation, by establishing strong BRAND LOYALTIES to established firms’ products, may act as a barrier to entry). Apart from the product-differentiation aspects, monopolistic competition is very similar structurally to PERFECT COMPETITION.
The analysis of individual firm equilibrium in monopolistic competition can be presented in terms of a ‘representative’ firm, that is, all firms are assumed to face identical cost and demand conditions and each is a profit maximizer (see PROFIT MAXIMIZATION), from which it is then possible to derive a market-equilibrium position.
The significance of product differentiation is:
- each firm has a market that is partially distinct from its competitors; that is, each firm faces a downward-sloping demand curve (D in Fig. 130 (a)), although the presence of close-competing substitute products (a high CROSS-ELASTICITY OF DEMAND) will cause this curve to be relatively elastic;
- the firm's cost structures (MARGINAL COST and AVERAGE COSTS) are raised as a result of incurring differentiation expenditures (SELLING COSTS).
The firm, being a profit maximizer, will aim to produce at that price (OPe )-output (OQe) combination, shown in Fig. 130 (a), which equates marginal cost (MC) and MARGINAL REVENUE (MR). In the short run, this may result in firms securing ABOVE-NORMAL PROFITS.
In the long run, above-normal profits will induce new firms to enter the market, and this will have the effect of depressing the demand curve faced by established firms (i.e. push the demand curve leftwards, thereby reducing the volume of sales associated with each price level). The process of new entry will continue until the excess profits have been competed away. Fig. 130 shows the long-run equilibrium position of the ‘representative’ firm. The firm continues to maximize its profits at a price (OPe )-output (OQe) combination where marginal cost equals marginal revenue but now secures only a NORMAL PROFIT return. This normal profit position for the firm in the long run is similar to the long-run equilibrium position for the firm in perfect competition. But monopolistic competition results in a less efficient MARKET PERFORMANCE when compared to perfect competition. Specifically monopolistically competitive firms produce lower rates of output and sell these outputs at higher prices than perfectly competitive firms. Since the demand curve is downwards sloping, it is necessarily tangent to the long-run average cost curve (which is higher than the perfectly competitive firms’ cost curve because of the addition of selling costs) to the left of the latter's minimum point. Firms thus operate a less than optimum scale of plant, and as a result there is EXCESS CAPACITY in the market.