Monopolistic competition: many firms with differentiated products, short-run abnormal profit competed away to long-run normal profit and excess capacity; and contestable markets where the threat of entry constrains behaviour.

What this key area is asking

Between the textbook extremes of perfect competition and monopoly sit the structures that fit most real markets. Monopolistic competition describes many small firms selling differentiated products (cafes, hairdressers, takeaways): each has a little market power but free entry erodes profit. Contestable market theory then makes a powerful point: what disciplines a firm may be the threat of entry rather than the number of rivals actually present. You must derive the long-run equilibrium of monopolistic competition with its excess capacity, and explain contestability and its policy lesson.

Monopolistic competition: the features

Because products are differentiated, each firm is a slight "monopolist" of its own version, but because entry is free, it cannot keep abnormal profit, hence the name.

Short-run and long-run equilibrium

In the short run the firm maximises profit at $MC = MR$ (with $MR$ below $AR$) and may earn abnormal profit. But free entry changes the long-run outcome:

• Abnormal profit attracts new firms, which draw customers away.
• Each existing firm's demand curve shifts left and becomes more elastic (more substitutes).
• Entry stops when only normal profit remains.

The excess capacity result

This is the central result. Monopolistic competition delivers variety and choice, which consumers value, but at the cost of slightly higher prices and unused capacity compared with the perfectly competitive ideal. The inefficiency is the price society pays for differentiation.

Contestable markets

Contestable market theory shifts attention from how many firms exist to whether entry is easy.

The crucial insight is that the credible threat of entry, even if entry never actually happens, disciplines incumbents. To avoid attracting hit-and-run entrants, even a single firm in a perfectly contestable market keeps price close to average cost and earns only normal profit.

The policy lesson of contestability

Because behaviour depends on contestability rather than the number of firms:

• A market with few firms can still behave competitively if it is contestable.
• A protected monopoly, by contrast, can exploit consumers.
• The policy implication is to lower entry barriers and reduce sunk costs, for example through deregulation and removing legal protections, rather than simply trying to increase the number of firms.

This reframes competition policy around making markets open rather than merely crowded, and it is a favourite evaluation point in the intervention topic.

Worked example: the long-run tangency

Why this matters

These two models complete the spectrum of market structures and sharpen the efficiency arguments. Monopolistic competition shows that the cost of consumer variety is some inefficiency and excess capacity, a nuance beyond the textbook extremes. Contestability reframes the whole intervention debate: the right response to a concentrated market may be to make it easier to enter rather than to break it up, which is precisely the kind of evaluative judgement the Advanced Higher question paper and project reward.

Try this

Q1. Why does a firm in monopolistic competition earn only normal profit in the long run? [2 marks]

• Cue. Low entry barriers: any short-run abnormal profit attracts new differentiated rivals that draw away demand until each firm's $AR$ is tangent to $AC$, leaving only normal profit.

Q2. Explain what is meant by a "sunk cost" and why it affects contestability. [2 marks]

• Cue. A sunk cost is an irrecoverable cost of entry. High sunk costs deter hit-and-run entry because a firm cannot get the money back on exit, making the market less contestable.