Model Answer
0 min readIntroduction
Monopolistic competition is a market structure characterized by a large number of firms producing differentiated products, allowing each firm some control over its price. This differs from perfect competition where products are homogenous. The conditions outlined in the question – numerous firms, differentiated products, ignoring rival actions, and free entry – are hallmarks of this structure. Understanding the equilibrium conditions in such a market is crucial for analyzing real-world industries like restaurants, clothing, and retail. This answer will derive the equilibrium conditions for both an individual firm and the industry as a whole, based on these defining characteristics.
Equilibrium of an Individual Firm
An individual firm in monopolistic competition faces a downward-sloping demand curve due to product differentiation. This allows the firm some degree of market power, unlike firms in perfect competition. The firm maximizes profit by producing at the quantity where Marginal Revenue (MR) equals Marginal Cost (MC).
- Profit Maximization: MR = MC. This determines the optimal quantity (Q*) to produce.
- Price Determination: The firm charges a price (P*) based on its demand curve at the optimal quantity (Q*). P* > MC, indicating some market power.
- Short-Run Profit/Loss: In the short run, the firm can earn economic profits if P* > Average Total Cost (ATC) or incur losses if P* < ATC.
The firm’s demand curve is relatively elastic compared to a monopolist’s, but more inelastic than a perfectly competitive firm’s. This is because of the availability of close substitutes.
Equilibrium of the Industry
The key feature of monopolistic competition is free entry and exit. This dynamic drives the industry towards long-run equilibrium.
- Entry of New Firms: If firms are earning economic profits in the short run, new firms will enter the industry. This increases the number of substitutes available, shifting the demand curve faced by each existing firm to the left.
- Exit of Firms: Conversely, if firms are incurring losses, some firms will exit the industry. This reduces the number of substitutes, shifting the demand curve faced by the remaining firms to the right.
- Long-Run Equilibrium: Entry and exit continue until economic profits are driven to zero. In long-run equilibrium, P* = ATC, and the firm produces at the level where MR = MC. However, unlike perfect competition, P* > MC even in the long run due to product differentiation.
- Excess Capacity: A notable feature of monopolistic competition is that firms operate with excess capacity in the long run. This means they are not producing at the minimum point of their ATC curve.
Graphical Representation
The firm’s equilibrium can be visualized using a graph with quantity on the x-axis and price/cost on the y-axis. The demand curve (D) slopes downwards. The Marginal Revenue curve (MR) lies below the demand curve. The Marginal Cost curve (MC) intersects MR at the profit-maximizing quantity (Q*). The price (P*) is determined by the demand curve at Q*. The ATC curve shows the average total cost at Q*. In long-run equilibrium, the demand curve is tangent to the ATC curve at Q*, resulting in zero economic profit.
| Feature | Short Run | Long Run |
|---|---|---|
| Economic Profit | Positive, Negative, or Zero | Zero |
| Price (P) | P > MC or P < MC | P = ATC |
| Production Level | MR = MC | MR = MC |
| Entry/Exit | No entry/exit | Free entry/exit |
Conclusion
In conclusion, the equilibrium in monopolistic competition is characterized by firms producing differentiated products, maximizing profits where MR=MC, and experiencing zero economic profits in the long run due to free entry and exit. This results in a market structure that lies between perfect competition and monopoly, with firms having some degree of market power but facing relatively elastic demand curves. The presence of excess capacity is a defining characteristic, reflecting the trade-off between product differentiation and efficiency.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.