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Unit 12: Monopolistic Competition

The initial downward sloping demand curve of the firm is DD and MR is the corresponding Notes
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marginal revenue curve. SMC and SAC are the short run marginal cost and short run average cost
curves. We see that the SMC curve cuts MR from below at point E . The fi rm maximises profi ts at
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output Q and charges price OP or Q D. At Q output SAC = OC . It makes super-normal profi ts =
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area P DKC . The super normal profits of existing firms induce new firms to enter this market.
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As the number of firms and brands increases, the market share of each firm declines and each
firm is able to sell less at the same price. Hence, the demand curve of every individual fi rm slides

downwards, remaining parallel to itself.
This process of competition from new entry continues so long as the profits earned by a typical

firm are more than normal, i.e., so long as the demand curve lies above the AC curve.
The competition from new entry will stop and every firm will reach its long run equilibrium

output when profits are only normal and price is just equal to long run average cost. This happens
when the demand curve of an individual firm becomes DD , which is at a tangent to the LAC

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curve at point E . The marginal revenue curve MR corresponds to demand curve DD . Here
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LMC cuts MR from below at point G at output Q . Thus, the maximum profit that each fi rm can
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earn is only normal profit which is included in LAC. The point of tangency E , is therefore the

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position of the long run equilibrium of a firm where output is Q and price is P .
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!
Caution When there is competition only from new entry, the long run equilibrium of the
firm under monopolistic competition is reached under the following conditions:

1. Price = AR = LAC = OP (Figure 12.1)
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2. MR = LMC = GQ (Figure 12.1)
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3. Maximum Profit = Normal Profi ts

However, because the firm’s demand or average revenue curve is falling, the price is higher than
marginal revenue. Hence, under monopolistic competition, even though the long run equilibrium
price is = LAC, it is greater than LMC. This is because, at equilibrium, MR = LMC but price is
greater than MR. (Under perfect competition, price = minimum LAC = LMC).
Moreover, since the firm’s demand or average revenue DD is falling on account of product

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differentiation, it can be a tangent to the U-shaped LAC curve only when LAC is also falling. As
shown in Figure 12.1, the long run equilibrium position E will be at a point which is to the left
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of the minimum LAC. Thus, the long run equilibrium output Q is less than optimum output,
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Q (where LAC is at its minimum). The difference between Q and Q = (OQ – OQ ) shows
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the extent of excess or under utilised capacity. Equilibrium with excess capacity is therefore the
necessary consequence of product differentiation and monopolistic competition.
Task Analyse the “market entry and the vanilla syndrome” in the case of health and
retirement plans of insurance companies.
12.2.2 Equilibrium when Competition is through Price Variation
For the purpose of explaining the process of competition through price changes, two demand
curves for every individual firm are used.

The change in demand resulting from a change in price undertaken on the basis of assumption

that its competitors will not follow suit when it reduces its price leads the firm to expect that
the increase in its demand will be proportionately greater than the reduction in its price. The
perceived demand curve is therefore highly, though not perfectly, elastic. It falls but falls very
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