Monopolistic Competition

Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another (e.g. by branding or quality) and hence are not perfect substitutes.

Monopolistic competition as a market structure was first identified in the 1930s by American economist Edward Chamberlin, and English economist Joan Robinson.

Many small businesses operate under conditions of monopolistic competition, including independently owned and operated high-street stores and restaurants. In the case of restaurants, each one offers something different and possesses an element of uniqueness, but all are essentially competing for the same customers.

Monopolistic competition incorporates features of both perfect competition and monopoly. Monopolistic competition is a market structure in which:

1. A large number of firms compete 2. Each firm produces a differentiated product 3. Firms compete on product quality, price and marketing 4. Barriers to entry exist but are very low 5. Knowledge is widely spread between participants, but it is unlikely to be

perfect. For example, diners can review all the menus available from restaurants in a town, before they make their choice. Once inside the restaurant, they can view the menu again, before ordering. However, they cannot fully appreciate the restaurant or the meal until after they have dined.

6. Firms are price makers and are faced with a downward sloping demand curve. Because each firm makes a unique product, it can charge a higher or lower price than its rivals. The firm can set its own price and does not have to ‘take' it from the industry as a whole, though the industry price may be a guideline, or becomes a constraint. This also means that the demand curve will slope downwards.

7. Monopolistically competitive firms are assumed to be profit maximisers because firms tend to be small with entrepreneurs actively involved in managing the business.

Source: http://www.economicsonline.co.uk/Business_economics/Monopolistic_competition.html

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Some of assumptions in more detail

1: Large numbers of firms compete.

a) Small market share – each firms supplies a small part of the market. Consequently, although each firm can influence the price of its own product, it has little power to influence the market average price.

b) No market dominance – each firm must be sensitive to the average market price of the product. But it does not pay attention to any one individual competitor. Because all the firms are relatively small, no single firm can dictate market conditions

c) Collusion impossible – collusion is impossible when the market has a large number of firms.

2: Product Differentiation This is the practice of making a product that is slightly different from the products of competing firms. A differentiated product has close substitutes but it does not have perfect substitutes e.g. Adidas, Diadora, Etonic, Fila, Nike, Puma and Reebok.

3: Firms compete on product quality, price and marketingProduct differentiation enables a firm to compete with other firms in three areas: quality, price and marketing.

a) Quality – the quality of a product is the physical attributes that make it different from the products of other firms. Quality includes design, reliability, the service provided to the buyer and the buyer’s ease of access to the product. The website http://www.jdpower.com/home.php rates the quality of many products including automobiles, financial services, travel and accommodation services.

b) Price – because of product differentiation, a firm in monopolistic competition faces a downward-sloping demand curve. So, like a monopoly, the firm can set both its price and its output.

c) Marketing – because of product differentiation, a firm must market its product. This is done through advertising and packaging. A firm that produces a high-quality product wants to sell it for a suitably high price. To be able to do so, the firm must advertise and package its product in a way that convinces buyers that they are getting the higher quality for which they are paying. For example, drug companies advertise and package their brand-name drugs to persuade buyers that these items are superior to the lower-priced generic alternatives.

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4: Entry and Exit – in monopolistic competition, there are very low barriers to entry. Consequently, a firm cannot make an economic profit in the long run. When firms make economic profits, new firms enter the industry. This entry lowers prices and eventually eliminates economic profits. When economic losses are incurred, some firms leave the industry. Exit increases prices and profits and eventually eliminates the economic losses. In the long-run equilibrium, firms neither enter nor leave the industry and the firms in the industry make zero economic profit.

Equilibrium under monopolistic competition

In the short run supernormal profits are possible, but in the long run new firms are attracted into the industry, because of low barriers to entry, good knowledge and an opportunity to differentiate.

Monopolistic competition in the short run

At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal profits are possible.

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As new firms enter the market, demand for the existing firm’s products becomes more elastic and the demand curve shifts to the left, driving down price. Eventually, all super-normal profits are eroded away.

Loss-minimizing quantity

A firm might incur an economic loss in the short run. Here is an example. In this case, P < ATC.

Long-run equilibrium under Monopolistic Competition

In the long run, because of the absence of entry barriers, new entrants will enter the market attracted by supernormal profits (SNP). The overall market supply rises, causing the market price to fall. The demand for the existing firm’s product subsequently falls as its share of the market demand declines, SNP are competed away with the influx of new firms. Equilibrium in the long run is achieved when participating firms are making normal profits only. There is no further incentive for potential firms to enter the market.

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Long run equilibrium

Monopolistic Competition and Inefficiency

The firm is allocatively and productively inefficient in both the long and short run.

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The monopolistic firm is not producing at the point of full productive capacity (where MC cuts ATC at point Pe). The firms do not produce at the lowest point on its average total cost curve. In this regard, monopolistically competitive markets compare unfavourably to perfectly competitive markets.

Furthermore, on account of product differentiation and the subsequent market power that exists, price exceeds marginal cost (point of allocative efficiency occurs Ae where MC = AR).

Part of the explanation for such inefficiencies lie in the fact that advertising, branding and other forms of product differentiation constitute additional costs to the firm. The positive aspect of monopolistic competition is the wider product choice it offers to the consumer. Benefits such as improved quality and service may also result from non-price competition. Unfortunately, we gain variety at the expense of efficiency.

Illustration of mark-up (Price > MC i.e. allocatively inefficient) and excess capacity (productively inefficient)

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Do Product Development and Marketing benefit the consumer?

Product Development and Innovation

To enjoy economic profits, firms in monopolistic competition must be continually developing new products. The reason is that whenever economic profits are earned, imitators emerge and set up business. So to maintain its economic profit, a firm must seek out new products that will provide it with a competitive edge, even if temporarily.

Innovation and product development are costly activities but they bring in additional revenues. The firm must balance the cost and benefit at the margin (MC=MR).

Monopolistic competition brings to market many improved products that bring great benefits to the consumer. But many so-called improvements amount to little more than changing the appearance or giving it a different look to the packaging.

However, regardless of the opinion above, because price exceeds marginal cost in monopolistic competition, product innovation is not pushed to its efficient level.

Marketing

Firms in monopolistic competition incur huge costs to ensure that buyers appreciate and value the differences between their own products and those of their competitors. Advertising expenditures and other selling costs affect the profits of firms in two ways. They increase costs and they change demand.

Advertising costs and other selling costs (promotion) are fixed costs. So just like fixed production costs, advertising costs per unit decrease as production increases.

If advertising increases the quantity sold by a large enough quantity it can lower ATC. The reason is that although the total fixed cost has increased, the greater fixed cost is spread over a greater output so ATC decreases.

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Example of advertising and effect on average total cost

Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced. Here, with no advertising, the firm produces 25 units of output at an average total cost of $60.

With advertising, the firm produces 100 units of output at an average total cost of $40. The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.

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Advertising might also decrease the markup.

With no advertising, demand is not very elastic and the markup is large. Advertising makes demand more elastic, increases the quantity and lowers the price and markup.

Does it increase or decrease demand?

The most natural answer is that advertising increases demand. By informing people about the quality of its product or persuading people to switch products, demand should rise.

But all firms in monopolistic competition advertise. If their advertising campaign is not seen as successful, it could lower the demand for the individual firm’s product.

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Questions

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2: Bianca bakes delicious cookies. Her total fixed cost is $40 a day, and her average variable cost is $1 a bag. Few people know about Bianca’s Cookies, and she is maximizing her profit by selling 10 bags a day for $5 a bag. Bianca thinks that of she spends $50 a day on advertising she can increase her market and sell 25 bags a day for $5 a bag.

a) If Bianca’s belief about the effect of advertising is correct, can she increase her economic profit by advertising?

b) If she advertised, would her average total cost increase or decrease at the quantity produced?

c) If Bianca’s belief about the effect of advertising is correct, would she continue to sell her cookies for $5 a bag, or would she raise or lower her price?

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