Your local barber can charge a little more than the one down the road and still keep most customers, because people like their haircut. That tiny bit of power over price is the whole idea of monopolistic competition — a market with lots of small firms where every product is slightly different.
📘 What you need to know
Many small firms, each acting independently, with low barriers to entry and exit.
Products are differentiated — similar, but branded or slightly different, so customers have preferences.
That differentiation gives each firm a little market power, so AR slopes down and MR lies below it.
Demand is relatively elastic because there are many close substitutes.
Short run: abnormal profit or losses are possible.
Long run: entry and exit push the firm back to normal profit, where AR is tangent to AC.
It is neither allocatively nor productively efficient, but it does give consumers plenty of choice.
What makes it different from the other three
Not perfect competition, because products are not identical. A branded haircut is not a commodity, so the firm can nudge its price up without losing everyone.
Not oligopoly, because there are many firms and none of them is watching the others closely. No interdependence, no game theory.
Not monopoly, because entry is easy. Any abnormal profit is temporary.
Typical examples: hairdressers, nail bars, cafes, plumbers, corner shops, small restaurants.
Think of it as perfect competition wearing a brand. Everything about entry and long-run profit is the same. The only change is that the flat demand line has tipped slightly downwards.
Short run: abnormal profit is possible
The rule does not change. Produce where MC = MR, then read the price up on the AR curve. If AR is above AC at that output, the firm makes abnormal profit.
The slope of AR is the whole story. Steep AR means few substitutes and real power; gentle AR like this means a small price rise sends most customers elsewhere.
Long run: the profit gets competed away
Barriers to entry are low, so abnormal profit does not last. Here is the chain:
New firms see the abnormal profit and open up nearby.
Customers are now shared between more firms, so each firm’s demand curve shifts left.
Demand also becomes more elastic, because there are now more substitutes.
Entry stops only when AR just touches AC — the firm covers its costs exactly and makes normal profit.
The tangency point is not at the bottom of AC. That small gap between where the firm produces and where AC is lowest is called excess capacity, and it is the price we pay for having lots of choice.
Efficiency: it fails both tests
Not allocatively efficient
At Q2, price (AR) is above MC. Consumers value extra units more than they cost to make, but those units are not produced.
Not productively efficient
The firm produces where AC is still falling, not at its minimum. Each firm is a little too small, so unit costs are higher than they need to be.
🤔 Why we accept the inefficiency anyway
Fifty half-full cafes on one high street are technically wasteful — ten large ones would produce coffee more cheaply. But you would get ten kinds of coffee instead of fifty. Monopolistic competition trades a little productive efficiency for a lot of choice and variety, and most people judge that a fair swap. That is your evaluation paragraph.
Comparing the diagrams. Monopoly and monopolistic competition look almost identical on paper. The difference is the slope of AR: steep and inelastic for monopoly, shallow and elastic here — and in the long run, monopolistic competition ends up tangent to AC while monopoly keeps its profit.
Worked examples
WORKED EXAMPLE 1
A cafe in monopolistic competition sells 900 coffees a week. At the output where MC = MR, AR = $3.60 and AC = $2.90. (a) Calculate weekly profit. (b) State what happens to this profit in the long run. [3]
(a) Profit = (AR – AC) × Q= (3.60 – 2.90) × 900 = 0.70 × 900Weekly abnormal profit = $630(b) Long runLow barriers to entry → new cafes open → demand for this cafe shifts left.
Profit falls until AR = AC and only normal profit remainsName the barriers. “Low barriers to entry” is the phrase that earns the mark.
WORKED EXAMPLE 2
Explain why a firm in monopolistic competition is not productively efficient in the long run. [4]
Step 1: State the condition
Productive efficiency needs MC = AC, which happens at the lowest point of AC.
Step 2: Where the firm actually sits
In the long run AR is tangent to AC at the MC = MR output.
Step 3: Why that point is not the bottom
AR slopes downwards, so it can only touch AC where AC is still falling, to the left of the minimum.
Step 4: Name it
The firm produces below the lowest-cost output, leaving excess capacity.
AC is above its minimum, so productive efficiency is not achievedThe reason is geometric: a downward sloping line cannot touch a U-shaped curve at its lowest point.
💡 Exam tip
Draw AR clearly flatter than you would for a monopoly. The slope is the examiner’s first check.
In the long-run diagram, AR must touch AC, not cross it. Practise that tangency by hand.
Use the phrase excess capacity whenever efficiency comes up here. It is the signature term.
Say low barriers to entry explicitly whenever you explain the long run.
For evaluation, weigh the lost efficiency against choice, variety and innovation in service.
Remember there is no interdependence, so game theory does not belong in a monopolistic competition answer.
⚠ Common mix-up
Mixing it up with monopoly because of the name. This market has many firms and easy entry.
Drawing the long-run tangency at the bottom of AC. That is perfect competition, not this.
Saying firms make no profit in the long run. They make normal profit, which covers opportunity cost.
Bringing in collusion or payoff matrices. There are far too many firms for that here.
Claiming demand is perfectly elastic. It is elastic, but it still slopes down — that is the point.
Forgetting that the demand curve gets flatter as well as shifting left when new firms enter.
Up next: Government Responses to Market Power — regulators, price caps, fines and public ownership, and how well each of them actually works.
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