Monopolistic Competition — Group Equilibrium and Excess Capacity

Monopolistic competition, a model developed by Edward Chamberlin, describes markets with a large number of sellers offering products that are close substitutes for one another but not identical — real-world examples include toothpaste brands, restaurants, or tailoring shops in a locality. Because each seller's product is slightly differentiated (through branding, quality, packaging, or location), each firm faces a downward-sloping, though relatively flat (highly elastic), demand curve for its own variant, giving it LIMITED control over its own price — more than a price-taking perfectly competitive firm, but far less than a monopolist.

Firms also compete through selling costs — advertising and sales-promotion expenditure aimed at shifting a firm's own demand curve outward. Unlike production costs, which create the good itself, selling costs are incurred purely to persuade buyers to prefer this firm's own variant.

In the SHORT RUN, a monopolistically competitive firm sets output where $MC=MR$, exactly like a monopolist, and may earn super-normal profit if $P>ATC$ at that output. But because entry is relatively FREE (unlike monopoly), super-normal profit attracts new firms selling their own differentiated variants into the group. As new firms enter, each existing firm's own demand curve shifts LEFTWARD and becomes flatter (its market share is shared among more competing variants), and this entry continues until every firm's demand curve becomes just tangent to its average cost curve — the group equilibrium, at which every firm earns only normal profit, exactly as under perfect competition's long-run equilibrium. …