Monopolistic competition
Learning goals
After this page, you can:
- Recognize monopolistic competition — many sellers, each product a little different, easy entry — and tell it apart from perfect competition, oligopoly and monopoly.
- Explain the long run in two forces, differentiation and entry, and compute a firm’s profit at each stage.
- Connect it to your memo: a healthy margin can sit next to zero economic profit, and firms run below their cheapest volume.
The idea
A mid-size town has four car washes. One is touchless. One has free vacuums. One is next to the highway. One does a hand dry. Each can charge a bit more than its cost per wash, because some drivers like its version best. Then a fifth wash opens on the busy corner — and every owner notices a slower Saturday.
This market has a name: monopolistic competition. It has three marks:
- many sellers, each one small;
- each product is a little different — a style, a location, a menu;
- it is easy to open a new one (and easy to close).
Restaurants, hair and nail salons, car washes, gyms, and most phone apps fit this picture. Compare the neighbors. In perfect competition (Week 4) the products are identical, so no seller can charge more than the market price. In monopoly (Week 5) there is one seller and no close substitute. In oligopoly (this week’s other pages) a few big sellers watch each other closely. Monopolistic competition sits in between: lots of rivals, but each one has a small corner of the market to itself.
Force 1: differentiation gives some pricing power. Because its version is a little different, each car wash has its own downward-sloping demand. Raise the price a bit, and some drivers leave, but not all. The wash uses the Week 5 rule: pick the volume where marginal revenue equals marginal cost, then read the price off its own demand line. That price is above marginal cost. So far, it looks like a small monopoly.
Force 2: entry takes the profit away. But anyone can open a car wash. If the existing washes make an economic profit, new ones open. Each new wash takes a few drivers from every old one. So each wash’s demand line slides down: fewer drivers at every price. The best price falls and the volume falls. Entry keeps going as long as there is any profit to be had. It stops when the best price just equals average cost — the cost per wash including the rent and wages. At that point economic profit is zero. (Economic profit already counts a normal return for the owner, so zero is not a disaster. It just means no extra reward to attract more rivals.) If profit turns negative, a wash closes, and the others get a few more drivers.
Market power but no profit. Here is the strange result. In the long run, each car wash still prices above marginal cost. Its markup — the Lerner index from Week 5 — can be large. Yet its economic profit is zero. Where did the markup go? It pays the fixed cost of being different: the rent on a good corner, the special equipment, the staff. A big gross margin is not proof of big profit.
Empty bays. One more result. Each car wash’s average cost would be lower if it sold more washes, because the fixed cost would be spread over more cars. So why not cut the price and fill the bays? Because the demand line slopes down. To sell twice as many washes, the price would have to fall below the new, lower average cost. So each wash runs below its cheapest volume. Empty tables in restaurants and empty chairs in salons are the same story. This is called excess capacity.
For your memo. If your company has many small rivals with similar products, say so. Name what makes yours different — that is the source of its margin. And say what entry is doing: if new rivals keep opening, expect the margin to be squeezed toward the fixed costs it has to cover.
One firm’s demand P = A − b·q · marginal revenue MR = A − 2b·q · best plan where MR = MC, price read off the demand line
Average cost AC = c + F ÷ q · Profit = (P − c) × q − F · Lerner index = (P − c) ÷ P
Long run: entry shifts each firm’s demand down until, at the best plan, P = AC (zero economic profit) while P > MC.
Try it
The explorer shows one car wash on Route 14 (fictional): cost per wash $4, fixed cost $400 a day, and demand P = 4 + 48 ÷ n − 0.04·q, where n is the number of car washes in town.
- Start at four car washes. Is the rectangle green or red? What does the status line tell you to do?
- Slide n up one step at a time. At which n does profit reach about zero? Then press Let the market settle and check.
- At the settled point, read the Lerner index. Is the markup zero? Is the profit zero?
- Raise the fixed cost to $600 and press Let the market settle again. Do more or fewer car washes survive?
Worked example
Problem. Route 14 car washes (fictional). Each wash costs $4 to provide, and each business pays $400 a day in rent and wages. One wash’s demand is P = 4 + 48 ÷ n − 0.04·q. Find each wash’s best plan and profit as more washes open.
Step 1. Four washes. A = 4 + 48 ÷ 4 = 16. Best plan q = (16 − 4) ÷ (2 × 0.04) = 12 ÷ 0.08 = 150 washes a day. Price = (16 + 4) ÷ 2 = $10. Average cost = 4 + 400 ÷ 150 = $6.67. Profit = (10 − 4) × 150 − 400 = $500 a day → new washes want in.
Step 2. Five washes. A = 4 + 9.60 = 13.60. q = 9.60 ÷ 0.08 = 120 at $8.80. Profit = 4.80 × 120 − 400 = $176 → still worth opening one more.
Step 3. Six washes. A = 12. q = 8 ÷ 0.08 = 100 at $8. Average cost = 4 + 400 ÷ 100 = $8. Profit = $0: entry stops. A seventh wash would mean about 86 washes at about $7.43, and a loss of about $106 a day, so a seventh wash would not last.
Step 4. Market power but no profit. At six washes the price, $8, is twice the $4 cost per wash. Lerner = (8 − 4) ÷ 8 = 0.50 — a healthy margin. Yet profit is zero: the $400 of margin a day exactly pays the $400 of fixed cost.
Step 5. Empty bays. At 200 washes, average cost would be 4 + 400 ÷ 200 = $6. But the demand line says 200 washes sell only at 12 − 0.04 × 200 = $4. Revenue $800, cost $1,200: a $400-a-day loss. So every wash stays below its cheapest volume.
Manager’s point. A big gross margin is not proof of big profit. In a market like this, the margin pays for the fixed cost of being different.
Check yourself
Four car washes in a town each sell 150 washes a day at $10. Each wash costs $4 to provide (water, soap, power), and each business pays $400 a day in rent and wages. What is one car wash’s daily economic profit?
Profit = (P − cost per unit) × units − fixed cost; positive profit invites entry.
Which business is the best example of monopolistic competition?
Many sellers + slightly different products + easy entry = monopolistic competition.
After more car washes open, each of six sells 100 washes a day at $8. Each wash costs $4 to provide, and each business pays $400 a day in fixed costs. Which statement is right?
Long run: price above marginal cost, but equal to average cost — market power with zero economic profit.
At 100 washes a day a car wash’s average cost is $8; at 200 washes it would be $6 ($4 + $400 ÷ 200). Its demand line is P = 12 − 0.04·q. Why doesn’t it cut its price to fill its empty bays?
Firms in monopolistic competition run below their cheapest volume because more volume needs a price below average cost.
With five car washes, each charges $8.80 and sells 120 washes a day. Each wash costs $4 to provide, and fixed costs are $400 a day. What is a wash’s daily profit, and what happens next?
Entry continues as long as economic profit is above zero.
Video
Video coming soon.