Monopolistic competition blends elements of perfect competition and monopoly. Firms offer similar but differentiated products, giving them some control over pricing. This market structure is common in everyday life, from restaurants to clothing brands.

In the long run, firms in monopolistic competition earn zero economic profit. While this resembles perfect competition, inefficiencies persist due to excess capacity and prices above marginal cost. The trade-off is greater product variety for consumers.

Monopolistic Competition

Product Differentiation

• Firms differentiate products to distinguish from competitors
  • Physical attributes (design, features, quality)
  • Intangible factors (brand image, customer service)
  • Location (convenience, accessibility)
• Differentiation creates perceived differences among functionally similar products
  • Allows firms some control over price
  • Firms face downward-sloping demand curve (more price flexibility)
• Non-price competition through advertising and marketing
  • Highlights unique features to attract customers
  • Builds brand loyalty and recognition

Price and Quantity Determination

• Profit maximization: firms set output where marginal revenue equals marginal cost ($MR = MC$)
• Downward-sloping demand curve due to product differentiation
  • Some market power to set prices above marginal cost
  • Not price takers like in perfect competition
• Short-run equilibrium: firms may earn profits, break even, or incur losses
  • Depends on demand curve and cost structure
  • Often operate with excess capacity (producing less than minimum efficient scale)

Long-Run Equilibrium

• Low barriers to entry and exit
  • Economic profits attract new firms
  • Losses lead to firms exiting the market
• Long-run equilibrium: entry and exit drive economic profits to zero
  • Firms produce where $MR = MC$ and average total cost equals price ($ATC = P$)
  • No incentive for firms to enter or exit
• Inefficiencies compared to perfect competition
  • Excess capacity (producing below minimum efficient scale)
  • Prices higher than marginal cost (deadweight loss)
• Trade-off between efficiency and product variety
  • Differentiated products cater to diverse consumer preferences
  • Sacrifices some efficiency for greater choice