Monopolistic competition

50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.

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1A firm in monopolistic competition faces a downward-sloping demand curve because:

A there are high barriers to entry, so it is protected from new competition in its market
B its product is differentiated, so some customers will pay more for it than for a rival's
C it has agreed with the other firms in the market to keep prices above the competitive level
D it is the only seller in the market and faces the whole of the market demand curve

2Which of the following markets comes closest to monopolistic competition?

A mobile network operators in the UK
B wheat farming
C the supply of water to homes in a region
D hairdressers in a large town

3In the short run, a firm in monopolistic competition making abnormal profit produces where:

A average cost is at its minimum, with price equal to average cost
B price equals marginal cost, with average cost at its lowest point
C marginal cost equals marginal revenue, with price above average cost
D average revenue equals average cost, with marginal revenue above marginal cost

4Firms in a monopolistically competitive market are earning abnormal profit. In the long run, for each existing firm:

A demand falls and becomes more elastic as new firms enter, until AR is tangent to AC
B demand rises and becomes less elastic as weaker rivals leave the market in the face of competition
C the price rises, because as a price maker the firm can pass any increase in costs on to its customers
D costs fall as the firm gains economies of scale, so abnormal profit is restored at the old price

5On the long-run diagram for monopolistic competition, the average cost curve is:

A cut by the downward-sloping average revenue curve at two points, one on either side of the minimum
B tangent to the downward-sloping average revenue curve at the profit-maximising output
C below the average revenue curve at every output, so that abnormal profit is earned at any price
D horizontal at the market price, because the firm can sell any quantity it chooses at that price

6In long-run equilibrium, a firm in monopolistic competition is productively inefficient because:

A it produces on the falling part of its average cost curve, to the left of the minimum
B it sets price equal to marginal cost, which is below its average cost at that output
C it produces more than the output at which average cost is lowest, so diseconomies set in
D it earns abnormal profit in the long run, which it does not need to compete away

7In long-run equilibrium, a firm in monopolistic competition is allocatively inefficient because:

A it earns abnormal profit
B average cost is at its minimum
C price is below average cost
D price is above marginal cost

8Compared with perfect competition, consumers in a monopolistically competitive market are more likely to benefit from:

A lower prices
B perfect information about every product
C greater variety and choice of products
D output at the minimum of average cost

9Which of the following best explains why firms in monopolistic competition earn only normal profit in the long run?

A they are price takers, so price is driven down to the level of average cost
B barriers to entry are low, so profits attract new firms
C they collude to share the market, so no firm earns more than any other
D their products are homogeneous, so no firm can charge more than its rivals

10A firm in monopolistic competition is making a loss in the short run. On its diagram:

A the firm produces where price equals marginal cost, and that price is below its average variable cost
B marginal revenue is above average revenue, so each extra unit sold reduces the firm's total revenue
C the average cost curve lies above the average revenue curve at the output where MC = MR
D average revenue is horizontal at the market price, so the firm cannot raise its price to cover costs

11A restaurant increases its spending on advertising. The most likely effect on the demand for its meals is that demand:

A shifts left and becomes more price elastic
B shifts right and becomes perfectly elastic
C is unchanged, because its rivals also advertise
D shifts right and becomes less price elastic

12The 'excess capacity' of firms in monopolistic competition refers to:

A the gap between their long-run output and the output at which average cost is lowest
B the abnormal profit they earn in the long run because entry does not fully compete it away
C unsold stock that builds up when rival firms cut their prices during a period of price competition
D the number of new firms that enter the market when existing firms are seen to be earning high profits

13Independent coffee shops are among the most common new businesses on UK high streets. Opening one needs little more than premises, a machine and staff, and many close within three years. Table 1 shows the position of one coffee shop in a town with a dozen others. Figures are illustrative.

Table 1: One coffee shop, per week
	Year 1	Year 3
Cups sold	1,500	1,100
Average price per cup (£)	3.40	3.20
Average total cost per cup (£)	2.80	3.20

(a)Using Table 1, calculate the coffee shop's weekly abnormal profit in Year 1. [2]

(b)Explain two features of the coffee shop market that make it monopolistically competitive. [4]

(c)With the aid of a diagram, explain the change in the coffee shop's position between Year 1 and Year 3. [6]

(d)Explain why the coffee shop in Year 3 is neither productively nor allocatively efficient, and one way in which consumers may still benefit from this market structure. [6]

14Evaluate the view that monopolistic competition benefits consumers more than perfect competition does. [20]

Answers

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	Answer	Why
1	B	Differentiation (branding, location, quality, service) gives each firm a degree of price-making power over its own customers.
2	D	Many small firms, easy entry and differentiated services describe hairdressing; water is a natural monopoly, mobile networks an oligopoly and wheat close to perfect competition.
3	C	Like any profit maximiser it sets MC = MR; abnormal profit means the price read off AR at that output is above AC.
4	A	With low barriers, entrants take some of each firm's customers and offer closer substitutes, shifting its demand curve left and flattening it until only normal profit remains.
5	B	Long-run equilibrium is normal profit (AR = AC) at the output where MC = MR; with a sloping AR that can only happen where AC just touches AR.
6	A	Tangency with a downward-sloping AR must occur where AC is still falling, so the firm has spare capacity.
7	D	With a downward-sloping demand curve, MR lies below AR, so at MC = MR the price exceeds marginal cost.
8	C	Differentiation is the source of the inefficiency and also of the choice consumers value; prices are higher, not lower.
9	B	Free entry is the key assumption: anything above normal profit draws in rivals until it is competed away.
10	C	A loss means price (on AR) is below average cost at the chosen output; MR and AR both slope down, with MR below AR.
11	D	Successful advertising wins customers and builds loyalty, so more is demanded at each price and buyers are less sensitive to price.
12	A	Because each firm produces to the left of minimum average cost, it could lower its unit cost by producing more; that unused scope is the excess capacity.

13 (a) Using Table 1, calculate the coffee shop's weekly abnormal profit in Year 1. [2]

(3.40 − 2.80) × 1,500 (1 mark)
£900 a week (1 mark)

13 (b) Explain two features of the coffee shop market that make it monopolistically competitive. [4]

Many small firms: a dozen shops in one town, each with a small share, so no single shop dominates (1 mark for the feature, 1 for applying it)
Differentiated products: each shop differs in location, coffee, atmosphere and service, which gives it some price-making power and a downward-sloping demand curve (1 mark for the feature, 1 for applying it)
Also credit: low barriers to entry and exit, shown by how easily shops open and how many close (1 mark for the feature, 1 for applying it)
Maximum 4: two features, each applied to the coffee market.

13 (c) With the aid of a diagram, explain the change in the coffee shop's position between Year 1 and Year 3. [6]

Diagram: downward-sloping AR and MR with MC and a U-shaped AC; Year 1 shows output at MC = MR with price above AC and an abnormal profit rectangle; Year 3 shows AR shifted left (and flatter) so that AC is tangent to AR at the new MC = MR output, normal profit only (2 marks)
Year 1 abnormal profit (£900 a week) attracted new shops because entry is easy (1 mark)
Entrants took some of the shop's customers and offered close substitutes, so its demand fell (cups sold down from 1,500 to 1,100) and became more price elastic (1 mark)
The shop was pushed down its demand curve to a lower price (£3.20) while average cost per cup rose as sales fell (£3.20), so price equals average cost: normal profit (1 mark)
This is the long-run equilibrium of monopolistic competition: the shop stays in business but earns no more than it could elsewhere (1 mark)
Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for correct diagrams with the entry mechanism; 5 to 6 for the diagram linked to the figures in the table and the tangency position explained.

13 (d) Explain why the coffee shop in Year 3 is neither productively nor allocatively efficient, and one way in which consumers may still benefit from this market structure. [6]

Productive inefficiency: at the tangency point AC is still falling, so the shop produces to the left of the minimum of average cost; it has spare capacity and could cut unit cost by selling more (2 marks)
Allocative inefficiency: at MC = MR the price (on AR) is above marginal cost, so the value customers place on the last cup exceeds the cost of making it and too little is produced (2 marks)
Consumer benefit: variety and choice (different coffees, settings, locations), non-price competition that improves quality and service, and the discipline of easy entry which keeps prices closer to cost than a monopoly would (2 marks for one benefit explained; credit a second benefit if the first is thin)

14 Evaluate the view that monopolistic competition benefits consumers more than perfect competition does. [20]

Analysis

Define both structures. Monopolistic competition: many firms, differentiated products, low barriers to entry, downward-sloping demand for each firm. Perfect competition: many firms, homogeneous products, perfect information, no barriers, price takers.
Against the view: in long-run equilibrium the monopolistically competitive firm charges a price above marginal cost (allocatively inefficient) and produces to the left of minimum average cost (productively inefficient, excess capacity); perfect competition delivers P = MC at minimum AC. Show the two long-run diagrams side by side. Consumers pay more per unit for less output.
Against: resources are spent on advertising and branding that create perceived rather than real differences, raising costs and prices without adding value; some differentiation is trivial.
For the view: differentiation gives consumers choice and products matched to different tastes (coffee shops, restaurants, clothing, hairdressers); a world of identical products at minimum cost is not what most consumers want.
For: non-price competition drives quality, service and innovation in ways perfect competition cannot reward, because an innovating firm in perfect competition gains nothing it can keep; low barriers to entry still discipline prices, so the price premium over perfect competition is small.
For: the model of perfect competition is rarely available in practice; the real comparison for most consumer markets is between monopolistic competition and oligopoly or monopoly, where monopolistic competition is the more competitive outcome.

Evaluation

It depends on how much consumers value variety against lower prices: for standard goods (milk, petrol) price matters most; for services and experience goods differentiation matters more.
It depends on how real the differentiation is: informative advertising and genuine quality differences add value; persuasive advertising that only shifts brand loyalty adds cost.
It depends on the size of the inefficiency: with many close substitutes demand is highly elastic, so the gap between price and marginal cost is small and the excess capacity modest.
Short run versus long run: in the short run monopolistically competitive firms may earn abnormal profit at consumers' expense; in the long run entry removes it.
Dynamic effects: some scope for retained profit and product innovation under monopolistic competition may benefit consumers over time in a way the static comparison misses.

Judgement

A supported judgement might conclude that perfect competition benefits consumers more on price and efficiency in a given period, but that monopolistic competition is likely to serve consumers better where variety, quality and service matter and where the price premium is small because entry is easy. For most real consumer markets the second description fits, so the view holds more often than not, but not for standardised goods.

Marking

Top band (16 to 20): a range of points developed in full chains of reasoning, supported by accurate diagrams and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation that is present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.