Problems of monopolistic competition
Another concern of critics of monopolistic competition is that it fosters advertising and the creation of brand names. Critics argue that advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. This is refuted by defenders of advertising who argue that brand names can represent a guarantee of quality, and (2) advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands. There are unique information and information processing costs associated with selecting a brand in a monopolistically competitive environment.
In a monopoly industry, the consumer is faced with a single brand and so information gathering is relatively inexpensive. In a perfectly competitive industry, the consumer is faced with many brands. However, because the brands are virtually identical, again information gathering is relatively inexpensive. Faced with a monopolistically competitive industry, to select the best out of many brands the consumer must collect and process information on a large number of different brands. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand (versus a randomly selected brand).
Evidence suggests that consumers use information obtained from advertising not only to assess the single brand advertised, but also to infer the possible existence of brands that the consumer has, heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised brand.
The demand curve
A monopolistically competitive firm faces a downward sloping demand curve but which is more elastic.
Demand Curves under Monopolistic competition.
Like with monopoly, the marginal revenue curve of a monopolistically competitive firm is down ward sloping and lies below the demand curve.
Similarly, the demand curve is also the average revenue curve.
Figure 3.41 .MR curve under monopolistic competition.
In the shortrun, the firm will be in equilibrium at a point where marginal revenue is equal to shortrun marginal cost (MR=SMC). In the shortrun, the firm earns abnormal profits but could also make losses.
The firm is making abnormal profits equivalent to shaded area OCPAB. It is in equilibrium at point E where MR=MC, producing output Q at a cost C and selling it at a price which is higher than the cost.
In the shortrun, the firm could also incur losses if output produced is OQ and the price is OP. the firm would incur losses equivalent to shaded area OPCAB. This is because at equilibrium point E ( Where MR=MC), the firm produces at a higher cost and sells at a lower price. The AC curve is above the AR curve hence losses.