In monopolistic competition, there are many small firms who all have very small shares of the market. Ex: hair salons.
Characteristics Monopolistic Competition
- Products are differentiated (based on things like service, quality or design)
- There are no barriers to entry
- Firms advertise and market their products (to differentiate them)
- Sales depends on the price of others and other non-price factors
- There is imperfect knowledge (people don’t know who is selling the good the cheapest or who has the best quality)
Short & Long Run Equilibrium
The diagram is the same as monopolies. The firm has the same short and long equilibrium and makes zero economic profits. Using the Profit Maximization Rule, MC = MR, we can find the quantity and draw a vertical line to the Demand curve, and thus find the corresponding price. The cost is found by drawing a vertical line from where Quantity meets the Average Cost curve to the price line.
Any signs of supernormal profits would create incentive for more firms to enter the market, and since there are no barriers to entry, firms will enter to make supernormal profits. This will continue till everyone makes normal or zero economic profits in the long run. Normal profits are break-even but it includes profits for the entrepreneur.
Even though there is allocative inefficiency (where Price exceed Marginal Cost) in monopolistic competition, there is a greater variety of products for the customer to choose from. However, costs rise because firms are forced to spend money on advertising.