Question

4. Perfect competition vs. monopolistic competition:

(a) What is the difference between perfect competition and monopolistic competition?

(b) Suppose the only long-run adjustment is free entry or exit of firms. What is the difference between the short-run equilibrium conditions faced by a perfectly competitive firm and a monopolistically competitive firm? How about the long-run equilibrium conditions?

Answer 1

a) Perfect Competition is a form of market structure in which there is free entry and exit of firms and firms are selling homogeneous and identical products in the market. Firms under this form of market are price takers rather than price makers. Industry determines the equilibrium price from the demand and supply curve intersection. Sellers can sell any unit of commodity at that price and firms does not have any price control over the commodity. If one seller try to charge higher price then it will lose all his customers because all firms are selling similar products in every respect like color, shape, brand, etc.

Monopolistic competition refers to a market situation in which there are large number of buyers and sellers. The sellers sell closely related or differentiated products but not identical product. The products are close substitutes of each other. Product differentiation is the most important feature of monopolistic competition. Each firm under monopolistic competition enjoys the monopoly over the brand of the commodity and thus the firm has the control over the price of the commodity. Under monopolistic competition, MR < AR and AR and MR curve slope downwards and MR curve lies below AR curve. But these curves are more elastic. Example: Firms producing different brands of shampoos like Sunsilk, Pantene, Head & Shoulders, Dove etc. Monopolistic competition combines the features of monopoly and perfect competition.

b) In short run, monopolistic firms are able to earn higher profit because of product differentiation while perfect competitive firm is price taker so not able to earn profit. Monopolistic firm has partial control over the price while perfectly competitive firm has no control over the price. Demand curve of perfectly competitive market is straight line while demand curve of monopolistic market is downward sloping.

In long run, there will be normal profit earned by both monopolistic competitive market and perfectly competitive market because of free entry and exit of firm.