Monopolistic competition

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit

Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another (that is, the products are substitutes but, because of differences such as branding, not exactly alike). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.^[1] In a monopolistically competitive market, firms can behave like monopolies in the short run, including by using market power to generate profit. In the long run, however, other firms enter the market and the benefits of differentiation decrease with competition; the market becomes more like a perfectly competitive one where firms cannot gain economic profit. In practice, however, if consumer rationality/innovativeness is low and heuristics are preferred, monopolistic competition can fall into natural monopoly, even in the complete absence of government intervention.^[2] In the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933).^[3] Joan Robinson is also credited as an early pioneer of the concept.

Monopolistically competitive markets have the following characteristics:

• There are many producers and many consumers in the 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.^[4]
• Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost the same as a perfectly competitive market. Two differences between the two are that monopolistic competition produces heterogeneous products and that monopolistic competition involves a great deal of non-price competition, which is based on subtle product differentiation. A firm making profits in the short run will nonetheless only 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 illustrates the amount of influence the firm has 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 the long run
• Independent decision making
• Market Power
• Buyers and Sellers have perfect information^[5][6]

Product differentiation

MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of demand between goods in such a market is positive. In fact, the XED would be high.^[7] MC goods are best described as close but imperfect substitutes.^[7] The goods perform the same basic functions but have differences in qualities such as type, style, quality, reputation, appearance, and location that tend to distinguish them from each other. For example, the basic function of motor vehicles is basically the same - to move people and objects from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles such as motor scooters, motor cycles, trucks, cars and SUVs and many variations even within these categories.

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".^[8] The fact that there are "many firms" gives each MC firm the freedom to set prices without engaging in strategic decision making regarding the prices of other firms and 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.^[9] Also the greater the degree of product differentiation - the more the firm can separate itself from the pack - the fewer firms there will be at market equilibrium.

Free entry and exit

In the long run there is free entry and exit. There are numerous firms waiting 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 without incurring liquidation costs. This assumption implies that there are low start up costs, no sunk costs and no exit costs. The cost of entering and exit is very low.

Independent decision making

Each MC firm independently sets the terms of exchange for its product.^[10] 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 heightened 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 they are low. Rather, an MC firm has market power because it has relatively few competitors, those 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".

Imperfect information

No sellers or buyers have complete market information, like market demand or market supply.^[12]

Market Structure comparison

	Number of firms	Market power	Elasticity of demand	Product differentiation	Excess profits	Efficiency	Profit maximization condition	Pricing power
Perfect Competition	Infinite	None	Perfectly elastic	None	No	Yes[13]	P=MR=MC[14]	Price taker[14]
Monopolistic competition	Many	Low	Highly elastic (long run)[15]	High[16]	Yes/No (Short/Long) [17]	No[18]	MR=MC[14]	Price setter[14]
Monopoly	One	High	Relatively inelastic	Absolute (across industries)	Yes	No	MR=MC[14]	Price setter[14]

Inefficiency

There are two sources of inefficiency in the MC market structure. 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. A 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.^[19]

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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 far exceed the benefits of such regulation. 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.^{[citation needed]}

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. Defenders of advertising dispute this, arguing that brand names can represent a guarantee of quality and that 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 market, the consumer is faced with a single brand, making information gathering relatively inexpensive. In a perfectly competitive industry, the consumer is faced with many brands, but because the brands are virtually identical information gathering is also relatively inexpensive. In a monopolistically competitive market, the consumer must collect and process information on a large number of different brands to be able to select the best of them. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand instead of 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.^[20]

Examples

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

Notes

1. ^ Paul Krugman, Maurice Obstfeld (2008). International Economics: Theory and Policy. Addison-Wesley. ISBN 0321553985. 
2. ^ The Free Market Illusion Psychological Limitations of Consumer Choice. http://www.econ.kuleuven.be/tem/jaargangen/2001-2010/2004/TEM2004-2/TEM%2004_2_5_POIESZ.pdf
3. ^ Monopolistic Competition. Encyclopedia Britannica. http://www.britannica.com/EBchecked/topic/390037/monopolistic-competition
4. ^ Joshua Gans, Stephen King, Robin Stonecash, N. Gregory Mankiw (2003). Principles of Economics. Thomson Learning. ISBN 0-17-011441-4. 
5. ^ Goodwin, N, Nelson, J; Ackerman, F & Weissskopf, T: Microeconomics in Context 2d ed. page 317 Sharpe 2009
6. ^ Hirschey, M, Managerial Economics Rev. Ed, page 443. Dryden 2000.
7. ^ ^{a b} Krugman & Wells: Microeconomics 2d ed. Worth 2009.
8. ^ Samuelson, W & Marks, S: 379. Managerial Economics 4th ed. Wiley 2003.
9. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 485. Pearson 2008
10. ^ ^{a b} 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 pages 224-25 Pearson 2003
14. ^ ^{a b c d e f} Perloff, J: Microeconomics Theory & Applications with Calculus page 445. Pearson 2008.
15. ^ Ayers, R & Collinge, R: Microeconomics page 280 Pearson 2003
16. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 424 Prentice-Hall 2001.
17. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 425 Prentice-Hall 2001.
18. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 427 Prentice-Hall 2001.
19. ^ 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 minimum. It is the point where the LRATC curve "begins to bottom out." Perloff, J: Microeconomics Theory & Applications with Calculus pages 483-84. Pearson 2008.
20. ^ Antony Davies & Thomas Cline (2005). "A Consumer Behavior Approach to Modeling Monopolistic Competition". Journal of Economic Psychology 26 (6): 797–826. doi:10.1016/j.joep.2005.05.003. 

See also

Economics portal

• Atomistic market
• Government-granted monopoly
• Imperfect competition
• Microeconomics
• Monopolistic competition in international trade
• Monopoly
• Natural monopoly
• Oligopoly
• Perfect competition
• Simulations and games in economics education

External links

• The Free Market Illusion Psychological Limitations of Consumer Choice by Th. B. C. Poiesz
• Monopolistic Competition by Elmer G. Wiens
• Monopolistic Competition Video Explanation by Prof. Vinod Kumar