Overview and assumptions of the model
- There are many firms.
- There are high barriers to entry.
- All firms are short-run profit maximisers.
- The firms and consumers have perfect knowledge about the good, in terms of technological advances.
- The good is non-homogenous between each firm. There is a perceived difference between the good of each firm.
Short-run and long-run equilibriumEdit
In Long-Run the price equals marginal cost (the profit-maximizing rule), and price equals short-run average total cost (zero economic profit). Short-Run equilibrium market price is determined by the interaction between market demand and market supply.
Monopolistic competition is distinguished by product differentiation which is a strategy in which one's firms product is distinguished from competing products by means of its design, related services, quality, location, or other attributes (except price). Monopolistically competitive firms turn out variations of a particular product. For example, there are so many different coffee shops a consumer can choose to go to, and each one serves the same drinks, but a specific location, a specific blend of beans, or a specific kind of drink can lead the consumer to go to one coffee shop verses another:
Product differentiation is unique in the sense that the difference of products does not actually have to exist in the sense of quality or price, but the difference must be assumed by the consumer. For example, two coffee shops may brew the exact same type of coffee for the exact same price, but one shop may use a more effective method of advertising to create the illusion that their coffee is better. The difference in prodcut is thus assumed, and not actually real.
Efficiency in monopolistic competitionEdit
Monopolistic competition does not efficiently allocate resources. The reason for this inefficiency is found with market control and negatively-sloped demand curve. The negative slope means that the price charged by the monopolistically competitive firm is greater than marginal revenue. As a profit-maximizing firm that equates marginal revenue with marginal cost, the price charged by monopolistic competition is also greater than marginal cost. The inequality between price and marginal cost is what makes monopolistic competition inefficient.