IB Docs (2) Team
Monopolistic competition (HL only)
Introduction
This lesson focuses on monopolistic competition. Your classes may have been unable to provide an example of a pure perfectly competitive market but will be able to provide several examples of industries in their area which are monopolistic in nature. Start by asking your class for examples of this type of market structure. The key point to state with this market structure is that while it may share many of the characteristics of perfect competition, the small level of differentiation between competing goods and services, leads to a significantly different market structure.
Enquiry question
What are the assumptions of monopolistic competition. How does this market structure differ from other structures in economics?
Lesson notes
Lesson time: 75 minutes (90 minutes if completing the extension exercise)
Lesson objectives:
Assumptions of the model and the revenue and cost curves in monopolistic competition.
Use diagrams to explain why in the long run a firm in monopolistic competition will make normal profit.
Distinguish, using examples, the difference between price competition and non-price competition.
Monopolistic competition and efficiency: Explain, using a diagram, why neither allocative efficiency nor productive efficiency are achieved by monopolistically competitive firms.
Compare and contrast, using diagrams, monopolistic competition with perfect competition and monopolistic competition with monopoly.
Teacher notes:
1. Beginning activity - begin with the two opening activities and allow 10 minutes for your classes to complete the question and discuss the video. (10 minutes)
2. Processes - technical Vocabulary - the students can learn the key concepts through the key terms and the first two activities. In activity 1 it is important to note that while the characteristics of perfect and monopolistic competition appear similar at first glance, the slight product differentiation means that the two market structures behave differently. Activities one and two, drawing the diagram, should take 15 minutes to go through and discuss.
3. Practise activities - included on the handout should take around 25 minutes. These are a combination of short answer and diagrammatic exercises.
4. Activity 6 - includes a video and essay type question. (15 minutes)
5. Final reflection exercise - contains a relevant paper one style question on this topic that your students can look at and discuss. This topic of course can be included on papers one and three of the examination and this page contains both types of questions to practise on. This activity could also be set as a homework or classwork exercise. (10 minutes)
6. Extension material is included on a video, which contains a speech by marketing guru Seth Godin. The video takes 15 minutes and you should follow the video by asking what the central message of the video is 'in a world where consumers have more choices than before but even less time, firms must stand out, they must be different'. (20 minutes)
Beginning activity
Consider the following industries in your local area:
- private taxi cars
- cafes and independent bars (not those which form part of a chain)
- hair dressers
- sellers of mobile phones (not the manufacturers).
Start by writing down some of the characteristics of these types of businesses.
Hint:
Examples probably include characteristics such as:
- many providers of those services
- the goods and services produced are substitutes for each other but not exact substitutes
- some brand loyalty - we all have our favourite hair dresser / cafe e.t.c.
- businesses will be relatively small.
In short you have probably described some or perhaps most of the characteristics of a monopolistic business.
Characteristics of monopolistic competition
1. Many firms selling the product as well as a large number of buyers, each too small to influence industry supply / demand and hence price. Each firm assumes that they are able to act independently of their competitors.
2. All firms in the market sell a similar but slightly different product. This means that some brand loyalty does exist, though this is likely to be restricted to small unique differences compared with other competing firms in the market. For example in a street there may be a large number of almost identical sandwich shops but each makes their sandwiches in a slightly different manner.
3. No barriers to entry or exit within the industry, making it a market that is easy to enter or leave the business when losses are made.
The activities on this page are available as a class handout at: 
Monopolistic firms
Activities
1. Look again at the characteristics of monopolistic firms. Which characteristics are similar to those of perfectly competitive firms and which do they share with monopoly firms?
(a) Why does brand loyalty make this structure different to perfectly competitive markets?
Monopolistic industrial structures share most of the characteristics of perfect competition, the only significant difference being that unlike firms in perfect competition monopolistic businesses sell goods which are slightly different. This creates a small degree of brand loyalty which changes the structure of firms,competing within a monopolistic structure. Brand loyalty, however small, means that the AR curve is highly elastic rather than perfectly elastic and so both the AR and MR curves slope downwards rather than perfectly elastic.
Activity 2
Drawing the demand curve?
On the blank diagram, draw the demand curve for a firm in monopolistic competition. The questions to consider are these:Will the demand curve be price elastic or inelastic (consider the number of substitutes). This should be called AR / D
Next draw the MR curve, falling at twice the gradient of the AR curve and a MC curve which should of course cut the AC curve at the lowest point. Then draw the profit maximising point where MC=MR.
Lastly draw an AC curve and plot the price and cost and also shade in the abnormal profit.
Activity 3: Efficiency in monopolistic competition
Your favourite hairdresser / sandwich bar / cafe raises their price so that it becomes slightly more expensive than other similar firms in the area. Do you stop going to your favourite place or continue your patronage at the slightly higher price?
Your response to this question is key to explaining why firms in monopolistic competition are neither productively or allocatively efficient. Because some customers continue to visit their favourite restaurant / cafe e.t.c., despite the slightly higher price, firms will produce at Q - slightly below the socially optimum level of output. Neither will firms in monopolistic competition produce where MC = AC.
In other words it is the customers choosing that the market is not efficient as it is derived from their own preference for slightly differentiated products.
Activity 4
Watch the following short presentation and then compile a list of ways that firms in competitive markets use non-competition to develop brand loyalty? Why do many firms prefer to use non-price competition, rather than price competition?
The presentation highlights the following: product differentiation including new models, sales promotions, customer service, quality of service, extensive marketing, i.e. anything not price.
Many businesses prefer this form of competition to competing directly on price because while methods such as advertising and product differentiation cost money to implement, they are still more economical than selling the products at a lower price and risking a price war.
Many businesses in perfect competition sell very similar products at very similar prices and so non-price competition is an essential way to differentiate different companies.
Activity 5
Complete the following table identifying the similarities between monopolistic competition and other market types?
| Perfect competition | Monopolistic competition | Monopoly | |
| Degree of PED elasticity? | perfectly elastic | very elastic | likely to be inelastic |
Abnormal profits can be made in the long run? | no | no | yes |
| Price takers or price makers? | price takers | firms have a little scope to set prices | price makers |
Productive / allocative efficiency in the long run? | yes | no | no |
| Are able to benefit from economies of scale? | no | no | yes |
| Degree of brand loyalty? | zero | small | significant |
Number of firms in the market? | many | many | one |
Activity 6
Watch the following short video and then explain why firms in monopolistic competition make normal profit in the long run.
The video begins with the assertion that one of the characteristics of monopolistic markets is that firms within it have a monopoly on their specific product, but not similar products competing in the same market space. For example, Apple is the owner producer of Ipads but there are a number of other competing firms making very similar products.
Therefore, in the short run when abnormal profits are made by Apple on the sale of Ipads, (green rectangle), other competing businesses e.g. Samsung divert resources into developing their versions of the Ipad, increasing overall supply in the industry. This reduces demand for Ipads, represented on the diagram by a fall in AR from AR1 to AR2 and MR from MR1 to MR2. This is simply a reflection of the new market situation, with Apple forced to reduce its prices (P1 to P2) and sell less units - Q1 to Q2, in the face of increased competition. This will not happen immediately but over time the abnormal profits will disappear. This will result in a new equilibrium point B, as supposed to A and the abnormal profit will disappear.
In a situation where losses were being made, Apple and other smart phone providers would reduce the resources they pour into those products and the price will rise until the losses disappear.
This is the result of the lack of entry barriers within those industries - firms in monopolistic competition have a monopoly on their own specific brand but cannot prevent other similar products entering the market.
Activity 7: Link to the assessment
Paper one questions on monopolistic competition include:
(a) Illustrate using a diagram why firms in monopolistic competition are neither productively or allocatively efficient in the long run. [10 marks]
Command term: Illustrate
Key terms to define: monopolistic competition, productive efficiency, allocative efficiency.
Responses should provide a diagram illustrating the long run equilibrium in monopolistic competition, with the firm producing at point Q, where AR ≠ MC and AC ≠ MC.
This can be explained by the fact that unlike perfect competition there is an element of brand loyalty in the market and this enables firms in monopolistic competition to charge a slightly higher price than the industry equilibrium.
In other words the customers preference for slightly differentiated products means that the market is not efficient as in perfect competition.
(b) Using real world examples, evaluate the view that monopolistic competition offers greater efficiency than industries controlled by a single dominant firm. [15 marks]
Command term: Evaluate
Key terms to define: monopolistic competition, monopoly, productive efficiency, allocative efficiency.
Real life examples might include industries best served by monopoly such as telecommunications where the gains from economies of scale are very large or where the market is not sufficient for more than one business to succeed in this market (natural monopoly). Responses should also include examples of where a market were the customer is best served by a large degree of competition in the market such as restaurants and bars or sandwich shops.
With the command term being evaluate responses must make a decision as to the validity of the claim stated in the question. On one hand the level of competition present in monopolistic competition forces down prices and leads to higher output and a greater variety of products available. Firms with inefficient production practises would be swept out of business by competition from similar businesses.
On the other hand firms in an industry controlled by a single dominant firm are likely to enjoy the benefits derived from increasing returns to scale. The diagram illustrates an example of a firm where the benefits from increasing returns to scale have resulted in lower prices (P1 rather than P2) and higher output, represented by Q2 compared to Q1.
Therefore, the validity of the claim is determined by the type of industry. Examples of industries where a monopoly might offer greater benefits to the consumer include airlines, telecommunications (where high profits can be ploughed back into the development of new products), postal delivery services and natural monopolies such as space travel. Industries likely to offer greater benefits from increased competition include cafes, coffee shops, hotels, taxi services and services such as hair dressers where the gains from increasing returns to scale are relatively limited.
Gamestop mania - is this a modern robin hood story or are larger players controlling the market
Watch the following short video and then decide for yourself.
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