Sunday, June 10, 2012

Monopolistic Competition Explained (Long Run)

I decided it's time to face my biggest fear and the bane of my existence...Monopolistic competitions. This concept took me forever to understand and it was the source of much frustration when I first took an introductory Econ course.

If you're like I was, however, don't worry! I finally understand it and I'm about to explain everything in simple terms.

I) Definition: A monopolistic competition is a type of competition in which there are two or more firms which sell similar products that are not perfect substitutes. For example, consider the toothpaste industry. Each toothpaste company essentially sells a product that you use on a daily basis to clean your teeth. However, each product is slightly different (the features they offer, the color, the branding/marketing, the target consumer). For example, one company may focus on encouraging the consumer to avoid heart disease, another company may focus on creating a flashy product with celebrity endorsements.

As you can see, each company is somewhat of a monopoly because there is no exact substitute. However, there is also competition because there are similar products that exist.

Now to explain the graph...
Above (Image 1) shows a graph of the overall graph. However, I will now explain how this graph is derived.

Step One: Demand line. Simple. Here it is:

Keep in mind that the demand curve in a monopolistic competition should appear to have a more 'shallow' downward slope because buyers are sensitive to a change in price. If Toothpaste company A, for example, increases their price 2 dollars, you would quickly switch to Toothpaste company B.

Step Two: Marginal Revenue Curve.
Self-explanatory diminishing marginal revenue curve. Keep in mind that it touches the demand curve only at one point. If you don't understand any of the shapes, see my previous posts explaining them.

Step Three: Marginal Cost Curve.
Find the point where Marginal Revenue = Marginal Cost. then, Trace it up to the demand curve. This is the profit maximizing point.
Again, if you don't understand any of the shapes, see my previous posts.

Step Four: Average Cost.
It is tangent to the point of maximizing profit (mentioned in step three) It falls then rises.

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