Monopolistic Competition vs. Perfect Competition in the long run

This post builds on our previous discussion of long run profit and equilibrium under perfect competition.

While a firm in monopolistic competition faces a downward facing demand curve, its short run profit maximization strategy will be the same as a firm in perfect competition (PC).

Again, a firm will produce where MR = MC. The difference here is that P > MR, whereas in PC with a horizontal demand curve P = MR.

Thus the graph of the short run on the left should look familiar.

 Monopolistic Competition

Monopolistic competition in the long run

So what happens in the long run? (Knowing this is key for possible multiple choice questions on the CFA exam).

Again because barriers to entry are low (like in PC) new firms will enter the market if economic profits are positive. This will increase the diversity of products in the marketplace, reduce demand for each individual firm, reduce profits, and drive price down to the ATC.

So what are the key differences between monopolistic competition and perfect competition?

  • In monopolistic competition Price ≠ MC, as a firm has the ability to mark up its price (so P > MC).
  • That means that the MR = MC level of output for each firm will actually occur at a less than efficient level (Q < efficient quantity)
  • Finally, because firms compete on product differentiation there tends to be greater product diversity and more frequent product innovations

One final thought on how this material will be tested on the Level 1 Exam:

In the CFA Level 1 Curriculum, monopolistic competition is a short section bridging longer sections between Oligopoly and Perfect competition. Don't let that fool you. It's important to know how ALL of the implications of changing the demand curve from flat to downward sloping in terms of firm profits, market reactions, and overall social welfare.