Monopolistic Competition: Pricing and Production Decisions | CFA Level I Economics

In this lesson, we’ll explore the pricing and production decisions for firms operating under monopolistic competition.

Characteristics of Monopolistic Competition

Monopolistic competition is marked by the following characteristics:

• Large number of independent sellers: Each firm has a relatively small market share, and no individual firm has significant pricing power.
• Low barriers to entry: Firms are free to enter and exit the market. If existing firms are earning economic profits, new firms can be expected to join the industry.
• Product differentiation: Firms produce slightly different products in terms of quality, features, and marketing, making them close substitutes for one another.

Under monopolistic competition, firms compete on price, quality and features, and marketing due to product differentiation. They can set their own price and output as they face downward-sloping demand curves.

Setting Prices and Output Levels

Though the demand curves for most firms are highly elastic, firms can make their demand curves less elastic by providing quality and features that consumers are willing to pay a premium for. Marketing is crucial to inform the market about these differentiating characteristics.

The demand curve is also the average revenue (AR) curve, but it is not the marginal revenue (MR) curve. For downward-sloping AR curves, the MR curve is also downward-sloping but steeper than the AR curve.

Profit Maximizing Level of Output

As we learned in our previous lesson, the profit-maximizing level of output is where marginal revenue equals marginal cost (MR = MC). We call this output level Q-star. At this level of production, if the average total cost (ATC) is lower than the price, the firm earns economic profits in the short run.

However, due to the low barriers to entry, new firms will enter the market if economic profits are available. As competition increases, the demand for each firm’s products decreases, shifting the demand curve downward until the price equals the average total cost (P = ATC) and economic profit equals zero. At this point, there is no incentive for new firms to enter the market, and long-run equilibrium is established.

Comparing Monopolistic Competition and Perfect Competition

In the long run, a firm under monopolistic competition sells at a higher price, has a higher average cost, and produces a lower quantity than under perfect competition. This suggests that the firm is not producing at the most efficient level.

In addition, economic costs in monopolistic competition include product differentiation costs, such as marketing and R&D. In perfect competition, there are minimal costs associated with marketing or R&D because all products are homogeneous. Prices are lower, but consumers may have limited variety.

And there you have it – a quick lesson on monopolistic competition. Up next, we’ll discuss oligopoly.