Monopolistic competition

Assumptions

• Many buyers and sellers.
• Differentiated products, so each firm has a little price-setting power: a downward-sloping (but quite elastic) demand curve.
• Low or no barriers to entry and exit.
• Firms are profit maximisers and act independently.

Product differentiation

Firms differentiate in three main ways:

• Physical: design, ingredients, quality, features.
• Marketing: branding, packaging, advertising, image.
• Distribution: location, opening hours, delivery, online ordering.

The aim is to make demand less price elastic, so the firm can charge more without losing all its customers.

Short-run and long-run equilibrium

Short run: the firm produces where MC = MR and may earn supernormal profit (AR above AC).

Long run: supernormal profit attracts new entrants with similar products, so each firm's demand curve shifts left (and becomes more elastic) until AR is tangent to AC at the MC = MR output. Only normal profit remains.

Diagram in words: downward-sloping AR and MR; U-shaped AC; AR just touches AC to the left of minimum AC, directly above where MC = MR.

Efficiency

In the long run: P > MC, so allocatively inefficient; output is to the left of minimum AC, so productively inefficient (firms have excess capacity). Little dynamic efficiency because there is only normal profit in the long run. But consumers gain choice and variety, which they may value more than slightly lower prices.

Worked example

A new bubble tea shop sells 500 drinks a week at $5 each with average cost $4. Find its profit and explain what happens in the long run.

1. Supernormal profit = (5 - 4) x 500 = $500 per week.
2. Low barriers: new tea shops open nearby.
3. Each shop's demand shifts left until AR is tangent to AC: normal profit only.

Answer: $500 a week now; normal profit in the long run, with excess capacity.

Check yourself

1. A restaurant in monopolistic competition sells 1,200 meals a month at $18 each with an average cost of $15. Find its supernormal profit.
   Show answer

   $3600. (18 - 15) x 1,200 = $3,600.

2. Opening later than rivals and offering home delivery is an example of
   • physical differentiation
   • price discrimination
   • distribution differentiation
   • collusion
   Show answer

   distribution differentiation. It is about how and when the product reaches customers.

3. In long-run equilibrium in monopolistic competition
   • the AR curve is tangent to the AC curve
   • the firm earns supernormal profit
   • price equals marginal cost
   • the firm produces at minimum average cost
   Show answer

   the AR curve is tangent to the AC curve. Entry removes supernormal profit, leaving AR = AC at the MC = MR output.

4. Firms in long-run monopolistic competition have excess capacity because
   • they produce where P = MC
   • barriers to entry are very high
   • they collude to restrict output
   • they produce to the left of the minimum point of AC
   Show answer

   they produce to the left of the minimum point of AC. The tangency point is on the falling part of AC.

5. Why do firms in monopolistic competition differentiate their products?
   • To make their product identical to rivals'
   • To make demand for their product less price elastic
   • To become price takers
   • To raise barriers to exit
   Show answer

   To make demand for their product less price elastic. Brand loyalty reduces the effect of a price rise on sales.

6. How does monopolistic competition differ from perfect competition?
   • There are high barriers to entry
   • There are only a few firms
   • Firms earn supernormal profit in the long run
   • Products are differentiated rather than identical
   Show answer

   Products are differentiated rather than identical. The number of firms and free entry are similar; the products are not.

7. Which is a benefit of monopolistic competition for consumers?
   • Prices equal to marginal cost
   • A wide choice of varied products
   • Production at minimum average cost
   • Large economies of scale
   Show answer

   A wide choice of varied products. Variety is the main gain; the static efficiency conditions are not met.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (XEC11/YEC11), Unit 3 Business behaviour and Appendices 6 and 7
• Pearson Edexcel IAL Economics WEC13/01 mark scheme, January 2021

Last updated 8 November 2026. Spotted a mistake? Tell us.