Lesson 3 of 7
Firms in monopolistic competition are price searchers. The products of firms under monopolistic competition have a downward sloping demand. The quantity the company can sell is inversely related to the price charged. The quantity sold depends on the price the firm chooses to charge. Elasticity is greater than 1, i.e., relatively elastic but not perfectly elastic. Small changes in price will have relatively large changes in quantity demanded.
The firms in price searcher markets face dual competition, i.e., from the existing firms as well as potential new entrants. There are lower barriers to entry. In the short run, if there are economic profits to be made, new rivals will enter the market until all profits have been eroded by firm entry. In the short run, firms in monopolistic competition act like monopolies. As long as MR > MC, firms will make economic profits. To maximize profits, firms will produce until MR = MC. When MC = MR, we get the profit maximizing output.
In the long run, companies making losses will exit and new firms will enter profitable businesses. This will shift the demand curve downwards. This will happen until price is equal to average total cost. The economic profit for all firms reduces to zero.
The differences between Perfect Competition and Monopolistic Competition are highlighted below:
| Perfect Competition | Monopolistic Competition | |
| Excess Capacity | The firm produces at its maximum capacity (Average Total Cost (ATC) is lowest). | Firm has excess capacity. The firm can sell more by reducing prices, however, to do so, they will produce at a level where cost > revenue. |
| Profit mark-up | Price = Marginal Cost | Price > Marginal Cost Mark-up is due to price discrimination as consumers get variety. Variety also increases cost. |
The quantity produces in monopolistic competition is less than efficient however the variety is valued by the consumers.