Monopolistic Competition

Monopolistic competition is a market structure in which the number of firms is large and there is free entry and exit, but the goods produced are not homogeneous. This structure is very common. There are, for example, a very large number of biscuit producers, but each biscuit carries a brand name, packaging and a slightly different taste. A consumer develops a taste for, or loyalty to, a particular brand and is not immediately willing to switch — yet if the price gap grows large enough, some consumers will switch to another brand, and the further the price is lowered, the more consumers shift.

Because of this, the demand curve faced by a monopolistically competitive firm is neither horizontal (as in perfect competition) nor the whole market demand curve (as in monopoly): it is downward sloping — the firm expects higher demand if it lowers its price. Since a firm's demand curve is also its $AR$ curve, the firm has a downward-sloping $AR$ curve, and its $MR$ lies below $AR$ and also slopes downward.

Being a profit maximiser, the firm produces where $MR = MC$. A perfectly competitive firm in the same situation would equate $AR$ (which for it equals $MR$) to $MC$; because the monopolistically competitive firm equates the lower $MR$ to $MC$, it produces less than the perfectly competitive firm, and — with lower output — the price is higher than under perfect competition. This describes the short run. …