Local taxi firms seek to differentiate themselves through factors such as pre-bookings, limousine service, or through a fleet of different cars. There are many firms in the market, yet cannot be considered perfectly competition due to: levels of differentiation, imperfect information on drivers, and the ability to make supernormal profits during peak periods.
There are many clothing manufacturers that distinguish themselves based on style, yet also have a certain level of market power. At the same time, it is relatively straight forward to manufacture clothes, with low barriers to entry.
There are thousands of hotels dotted over the country – each with a certain level of local market power. This classifies as monopolistic competition as there are many firms, each that offer a slightly different experience. At the same time, the cost to start a small hotel is relatively low. For instance, a business owner may be able to take out a loan to purchase a property, but they could leave the market relatively easily.
There are many separate restaurants all competing on the basis on slight differences. However, they are all competing for the same customer.
Often a large number of firms that use quality of service as a differentiator. Many customers will come back to the same hairdresser as they obtain trust and offer a quality of service. At the same time, there are low barriers to entry, with new stores opening frequently.
There are many soap brands, each with a slightly different style and scent. It’s difficult to really tell the difference which is why some offer to ‘kill 99.9% of bacteria’ and other slogans.
A necessity product, but one that has many competitors offering slightly different qualities and styles.
In the short-run, firms in monopolistic competition are able to make a supernormal profit. For example, a new clothing manufacturer may produce a new design that becomes an instant hit. In the short-term, customers flock to buy it.
However, competitors acknowledge this and will try and make similar designs, thereby taking customers back. In the long-run, competitors will flock into the market to make profits from the new design and reduce profits from supernormal to ‘ordinary’ profits.
As with all profit maximising firms, they will continue to produce until Marginal Revenue equals Marginal Cost. This means that if it is no longer profitable to produce a product, then the business will not do so. For example, Walmart will no longer sell its Cereal Brand for $2 if its Marginal Cost is greater.
As we can see from the graph above and below, average costs increase as new entrants enter the market. This is due to the fact that firms are unable to benefit from economies of scale.
To begin with, the firm making supernormal profits will increase production so that Marginal Costs = Marginal Revenue. However, when new businesses enter, they will take customers away; meaning the original firm will have to reduce production. In turn, this can lead to a more inefficient production process which increases the average cost to all businesses.
Over the long-run, average costs increase due to higher levels of competition, and profits fall to normalised levels. Firms will still aim to profit maximise, thereby increasing production until Marginal Revenue (MR) = Marginal Cost (MC).
This is shown on the diagram where MR and Long-run Marginal Cost (LRMC) intersects. The firm will then sell at the price at the point where it intersects the demand curve – which is at price PL. The long-run average costs then go through this point. At this point, the firm will make no profit in the long-run.
In monopolistic competition, firms operate where MR = MC, which is shown at quantity Q1 on the graph. However, the firm could produce up to where demand is equal to long-run marginal cost. This is because, at this point, the firm is producing at the exact cost the consumer is willing to pay. Yet the firm chooses to produce at a lower quantity at Q1 because it seeks to maximise profits.
At Q2, it can produce more and sell more goods, but its profits would be lower because its marginal costs are in excess of its marginal revenue. So the firm looks to reduce output in order to maximise profits. However, this means that consumers who would otherwise be willing to pay a lower price are unable to do so because the firm seeks to maximise profits. In turn, this leads to a deadweight loss for society as output is not allocatively efficient.