Monopolistic competition is one of the realistic types of market structure. In this type of market, many sellers provide differentiated products to many buyers. Sellers engage in advertising to highlight why their products are not the same as competitors’ products. Since each has its own brand, it has control over the prices charged.
Relatively low barriers to entry and exit
The barriers to entry and exit are surmountable such that many firms join the industry in the long run. The barriers include significantly lower unit cost, patents, sunk costs, huge capital requirement and exclusive access to inputs or components.
Many firms and many buyers
The existence of low barriers allows more firms to enter the market. In other words, it is relatively easy to set up a business in the market. This is similar to what is obtainable in perfect competition even though the number of players is not infinite.
The products sold are not homogeneous. Each firm sells a product that is slightly different from those of competitors. Each firm has its own brand which is often reinforced with advertising.
Control over price
Each firm can exercise some control over the price it charges for its product even though it has a very small market share. Since the products are not homogeneous, each firm can dictate its own price regardless of the prices others fix. The market participants are price makers because each of them can independently make its pricing decision.
The objective of the firms in a monopolistic competitive market is to maximise profit. This is achieved when the marginal revenue and marginal cost are equal. But a firm can only make abnormal profit in the short run. The abnormal profit will attract more firms into the market which results in the generation of a normal profit in the long run.
Short-run and long-run equilibrium
The firm produces at the output level where marginal revenue (MR) and marginal cost (MC) are equal. The average cost (AC) is below the average revenue (AR) leading to an abnormal profit in the short run. In Figure 1, the output Q occurs where MR is equal to MC as a profit maximiser. The rectangle PRST represents the abnormal profit made as the AR is greater than the AC.
In the long run, however, normal profit is made as AC and AR are equal (Figure 2 below). The relative ease of entry makes the short-run abnormal profit disappear in the long run.
Figure 1: Short-run equilibrium by a monopolistic firm
Figure 2: Long-run equilibrium by a monopolistic firm