Revision:Monopolistic competition

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The model of monopolistic competition lies halfway between perfect competition and monopoly. The following assumptions are made:

• Freedom of entry and exit
• Perfect knowledge
• Product differentiation takes place - real/imaginary differences between products creating consumer loyalty

The firm can raise its price without losing all its customers due to the existence of product differentiation. PD is assisted by advertising, which can steepen the demand curve.

Short run equilibrium

Abnormal profits are made.

Long run equilibrium

Free entry erodes profits. More firms enter the market, lowering the AR and MR of the incumbent firms. The AR and MR of these firms moves to the left, to the point where MR=MC and AC is tangent to the AR curve.

This is the tangency solution point.

How to draw the tangency solution point

1. Draw AR and MR (with the gradient of MR double AR)
2. Draw the AC, with a tangency point 3/4 of the way up the AR
3. Put in the price and quantity at this point
4. Draw in the MC. It should cross MR at the level of output you just drew in. It should cross the minimum of AC.

Evaluation

Price is higher and output is lower than under perfect competition. However, the consumer gains from the choice that product differentiation brings.

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