Monopolistic Competition 337differences, a spectrum of different prices can persist across supermarkets with-
out inducing enormous sales swings toward lower-priced stores.
Monopolistic competition is characterized by three features. First, firms
sell differentiated products. Although these products are close substitutes, each
firm has some control over its own price; demand is not perfectly elastic.
Second, the product group contains a large number of firms. This number (be
it 20 or 100) must be large enough so that each individual firm’s actions have
negligible effects on the market’s average price and total output. In addition,
firms act independently; that is, there is no collusion. Third, there is free entry
into the market. One observes that the last two conditions are elements drawn
from perfect competition. Nonetheless, by virtue of product differentiation
(condition 1), the typical firm retains some degree of monopoly power. Let’s
consider the output and price implications of these conditions.
Figure 8.5a shows a short-run equilibrium of a typical firm under monopo-
listic competition. Because of product differentiation, the firm faces a slightly
downward-sloping demand curve. (If it raises price slightly, it loses some, but not
all, customers to competitors.) Given this demand curve, the firm maximizes
profit by setting its marginal revenue equal to its marginal cost in the usual way.
In the figure, the resulting output and price are Q and P, respectively. Because
price exceeds average cost, this typical firm is earning positive economic profits.
In a long-run equilibrium, the free entry (or exit) of firms ensures that all
industry participants earn zero economic profits. Thus, in the long run, the
outcome in Figure 8.5a is not sustainable. Attracted by positive economic prof-
its, new firms will enter the market. Because it must share the market with a
greater number of competitors, the typical firm will find that demand for its
product will be reduced; that is, its demand curve will shift to the left.
Figure 8.5b shows the firm’s new long-run demand curve. As in part (a),
the firm is profit maximizing. The firm’s optimal output is QE, where marginal
revenue equals marginal cost. However, even as a profit maximizer, the firm is
earning zeroeconomic profit. At this output, its price, PE, exactly equals its aver-
age cost. In fact, the firm’s demand curve is tangent to (and otherwise lies
below) its average cost curve. Any output other than QE, greater or smaller,
implies an economic loss for the firm.
A comparison of Figures 7.3 and 8.5 shows the close correspondence
between the graphical depictions of monopolistic competition and perfect
competition. The essential difference centers on the individual firm’s demand
curve—either downward sloping (reflecting differentiated products) or infi-
nitely elastic (indicating standardized products that are perfect substitutes). In
both cases, the long-run equilibrium is marked by the tangency of the demand
line with the average cost curve. Under perfect competition, this occurs at the
point of minimum average cost. In contrast, the typical firm in monopolistic
competition (by virtue of its differentiated product) charges a higher price
(one above minimum average cost) and supplies a smaller output than its coun-
terpart in a competitive market.c08Monopoly.qxd 9/29/11 1:31 PM Page 337