Monopolistic competition

Short-run equilibrium of the firm under monopolistic competition

Monopolistic competition is a common market structure where many competing producers sell products that are differentiated from one another (ie. the products are substitutes, but are not exactly alike). Many markets are monopolistically competitive, common examples include the markets for restaurants, cereal, clothing, shoes and service industries in large cities. The "founding father" of the theory of monopolistic competition was Edward Hastings Chamberlin, in his pioneering book on the subject, Theory of Monopolistic Competition (1933).^[1]

Monopolistically competitive markets have the following characteristics:

• There are many producers and many consumers in a given market, and no business has total control over the market price.
• Consumers perceive that there are non-price differences among the competitors' products.
• There are few barriers to entry and exit^[2].
• Producers have a degree of control over price.

Long-run equilibrium of the firm under monopolistic competition

The characteristics of a monopolistically competitive market are almost the same as in perfect competition, with the exception of monopolistic competition having heterogeneous products, and that monopolistic competition involves a great deal of non-price competition (based on subtle product differentiation). A firm making profits in the short run will break even in the long run because demand will decrease and average total cost will increase. This means in the long run, a monopolistically competitive firm will make zero economic profit. This gives the amount of influence over the market; because of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm's demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

Major characteristics

There are six characteristics of monopolistic competition (MC):

• product differentiation
• many firms
• free entry and exit in long run
• Independent decision making
• Market Power
• Buyers and Sellers have perfect information^[3][4]

Product differentiation

MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as to eliminate goods as substitutes. Technically the cross price elasticity of demand between goods would be positive.In fact the XED would he high.^[5] MC goods are best described as close but imperfect subsitutes.^[6] The goods perform the same basic functions. The differences are in "qualities" and circumstances such as type, style, quality, reputation, appearance and location that tend to distinguish goods. For example, the function of motor vehilces is basically the same - to get from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles, motor scooters, motor cycles, trucks, cars and SUV"s.

Many firms

There are many firms in each MC product group and many firms on the side lines prepared to enter the market. A product group is a "collection of similar products"^[7]The fact that there are "many firms" gives each MC firm the freedom to set prices without engaging in strategic decision making.The requirements assures that each firm's actions have a negligible impact on the market. For example. a firm could cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors.

How many firms will an MC market structure support at market equilibrium? The answer depends on factors such as fixed costs, economies of scale and the degree of product differentiation. For example, the higher the fixed costs the fewer firms the market will support. ^[8]. Also the greater the degree of product differentiation - the more the firm can separate itself from the pack - the fewer firms there will be in market equilibrium.

Free entry and exit

In the long run there is free entry and exit. There are numerous firms awaiting to enter the market each with its own "unique" product or in pursuit of positive profits and any firm unable to cover its costs can leave the market withtout incurring liquidation costs. This assumption implies that there are low start up costs, no sunk costs and no exit costs.

Independent decision making

Each MC firm independently sets the terms of exchange for its product.^[9] The firm gives no consideration to what effect its decision may have on competitors.^[10] The theory is that any action will have such a negligible effect on the overall market demand that an MC firm can act without fear of prompting hightened competition. In other words each firm feels free to set prices as if it were a monopoly rather than an oligopoly.

Market power

MC firms have some degree of market power. Market power means that the firm has control over the terms and conditions of exchange. An MC firm can raise it prices without losing all its customers. The firm can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC firm's market power is not barriers to entry since there are none. An MC firm derives it's market power from the fact that it has relatively few competitors, competitors do not engage in strategic decision making and the firms sells differentiated product.^[11]Market power also means that an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although not "flat".

Perfect information

Buyers know exactly what goods are being offered, where the goods are being sold, all differentiating characteristics of the goods, the good's price, whether a firm is making a profit and if so how much. ^[12]

Comparing market structures

• Number of firms

PC: Infinite number of sellers

MC: Many seller within each product group

M: One seller

• Market power

PC: None

MC: Some

M: High

• Elasticity of demand

PC: Perfectly elastic

MC: Highly elastic^[13]

M:Relatively inelastic

• Product differentiation

PC: None

MC:high^[14]

M: Absolute

• Excess profits

PC: No

MC: No^[15]

M: Yes

• Efficiency

PC: Yes^[16]

MC: No^[17]

M: No

• Profit maximization condition^[18]

PC p =MR = MC

MC MR = MC

M MR = MC

• Ability to set price^[19]

PC Price taker

MC price setter

M price setter

Inefficiency

There are two sources of inefficiency in the MC market sturcture. First, at its optimum output the firm charges a price that exceeds marginal costs, The MC firm maximizes profits where MR = MC. Since the MC firm’s demand curve is downward sloping this means that the firm will be charging a price that exceeds marginal costs. The monopoly power possessed by an MC firm means that at its profit maximizing level of production there will be a net loss of consumer (and producer) surplus. The second source of inefficiency is the fact that MC firms operate with excess capacity. That is, the MC firm’s profit maximizing output is less than the output associated with minimum average cost. Both a PC and MC firm will operate at a point where demand or price equals average cost. For a PC firm this equilibrium condition occurs where the perfectly elastic demand curve equals minimum average cost. An MC firm’s demand curve is not flat but is downward sloping. Thus in the long run the demand curve will be tangent to the long run average cost curve at a point to the left of its minimum. The result is excess capacity. ^[20]

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While monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits; the government would have to regulate all firms that sold heterogeneous products—an impossible proposition in a market economy. A monopolistically competitive firm might be said to be marginally inefficient because the firm produces at an output where average total cost is not a minimum. A monopolistically competitive market might be said to be a marginally inefficient market structure because marginal cost is less than price in the long run.

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 disputed by defenders of advertising who argue that (1) 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.^[21]

Examples

In many U.S. markets, producers practice product differentiation by altering the physical composition, using special packaging, or simply claiming to have superior products based on brand images and/or advertising. Toothpastes and toilet papers are examples of differentiated products.

Notes

1. ^ monopolistic competition. Encyclopedia Britannica. http://www.britannica.com/EBchecked/topic/390037/monopolistic-competition
2. ^ Joshua Gans, Stephen King, Robin Stonecash, N. Gregory Mankiw (2003). Principles of Economics. Thomson Learning. ISBN 0-17-011441-4. 
3. ^ Goodwin, N, Nelson, J; Ackerman, F & Weissskopf, T: Microeconomics in Context 2d ed. page 317 Sharpe 2009
4. ^ Hirschey, M, Managerial Economics Rev. Ed, page 443. Dryden 2000.
5. ^ Krugman & Wells: Microeconomics 2d ed. Worth 2009.
6. ^ Krugman & Wells: Microeconomics 2d ed. Worth 2009.
7. ^ Samuelson, W & Marks, S: 379. Managerial Economics 4th ed. Wiley 2003.
8. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 485. Pearson 2008
9. ^ Colander, David C. Microeconomics 7th ed. Page 283. McGraw-Hill 2008.
10. ^ Colander, David C. Microeconomics 7th ed. Page 283. McGraw-Hill 2008.
11. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 483 Pearson 2008.
12. ^ Goodwin, N, Nelson, J; Ackerman, F & Weissskopf, T: Microeconomics in Context 2d ed. page 289. Sharpe 2009
13. ^ Ayers, R & Collinge, R: Microeconomics page 280 Pearson 2003
14. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 424 Prentice-Hall 2001.
15. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 425 Prentice-Hall 2001.
16. ^ Ayers, R & Collinge, R: Microeconomics pages 224-25 Pearson 2003
17. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 427 Prentice-Hall 2001.
18. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 445. Pearson 2008.
19. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 445. Pearson 2008.
20. ^ The firm has not reached full capacity or minimum efficient scale. Minimum efficient scale is the level of production at which the long run average cost curve first reaches its mimimum. It is the point where the LRATC curve "begins to bottom out." Perloff, J: Microeconomics Theory & Applications with Calculus pages 483-84. Pearson 2008.
21. ^ Antony Davies & Thomas Cline (2005). "A Consumer Behavior Approach to Modeling Monopolistic Competition". Journal of Economic Psychology 26: 797–826. doi:10.1016/j.joep.2005.05.003. 

See also

• Atomistic market
• Imperfect competition
• Microeconomics
• Monopolistic competition in international trade
• Perfect competition
• Simulations and games in economics education

External links

• Monopolistic Competition by Elmer G. Wiens