Monopolistic Competition

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1 Introduction to Microeconomics Monopolistic Competition Introduction In this document we refer to imperfect competition as monopolistic competition. Monopolistic competition is described as the situation where there are many firms competing but each firm has some degree market power and price setting choice. Each firm will face a downward sloping demand curve and acts to some extent as a monopoly. In the monopolistic market place there are many firms selling differentiated versions of the same product. As we will see below, if super profits are earned then each firms demand curve moves down as new firms will enter the market. As such profits subside back to their normal level. In spectrum of market structures this is second most competitive of the four. Characteristics of Monopolistic Competition There are four key characteristics that define monopolistic competition. Large number of firms: There are many firms in this market. Low barriers of entry: Any new firm can enter the market without any barriers of impediments. Often it is also the case that industry knowledge is shared across all participants, but no sellers or buyers have complete information. Given the recent advent of e-commerce this form of competition has increased as many similar but differentiated products are offered on a multitude of websites. More importantly this has significantly lowered the barriers to entry for many industries. roduct differentiation: Each seller sells a slightly different version of the essentially the same product. The differentiation can occur through product differentiation where the actual products are slightly different. A good example of this would be craft (micro) breweries. Differentiation can also occur through marketing and packaging which targets certain customers or attracts a premium through distinction. The human capital at a firm can also provide differentiation. For instance, some small financial, legal and accounting firms label themselves as boutique or specialists. In addition the method of sale or distribution can also be another factor in differentiation as evidenced by the recent growth in online sales compared to traditional retail. A small degree of price control: The producers get some degree of price control as they are selling differentiated products and they have a degree of monopoly power on their version of the good or service. Each firm has makes independent decisions about output and pricing according to its product and market. Firm operating under monopolistic competition are price makers and face a downward sloping demand curve and can impose a higher or lower price than its competitors. However more often than not the market price is guideline for the product and consumers are able to compare differentiated products against one another. 1

2 Monopolistic Competition Equilibrium SR AC SR LR SR SRMR Short Run LR Long Run In the diagram above profits are maximised when MC = MR. In the short run the firm can make super normal profits over and above normal profits. The more inelastic the demand curve the greater profit can be made in the short run. If a firm has little or no competition because their product is quite differentiated from the others in the market then the demand will be relatively inelastic and the firm can profit considerably from the short run super profits. If all the firms were to have very similar products then we would end up with a situation such as that of perfect competition, where the demand curve is flat. In the long run if super normal profits have been achieved, the demand curve is relatively inelastic, and barriers are low, new firms will enter the market. As new firms enter the market the demand curve for the existing firm becomes more elastic and flattens out. Also because it is a differentiated product the new products are substitutes so the demand curve will also shift downwards. It is obvious that the monopolistic firm will benefit in short run. Firms in the industry know that there is potential competition in the long run and therefore attempt to stay in the short run by constantly innovating and differentiating. This may be the reason for the small to medium business sector being often viewed as a large source for technology and product improvement. Allocative Inefficiency It is worth noting that in both the short and long run there is an inefficiency because the price is above the margin cost in both cases. This can be thought of it terms of a net loss to consumer and producer surplus. The allocation inefficiency is eroded as the ability to earn super profit decreases with more new firms entering the market. Another source of inefficiency is the fact that he firm will be operating with excess capacity. The profit maximising output is less than the output at the point of minimal average cost. Because the demand curve is downward sloping it is tangent to the average cost curve a point left of the minimum so it will produce at a higher point on the cost curve. In other words they could lower their costs by producing at the minimum point on the average cost curve, however this would eliminate the super normal profits they enjoy. 2

3 Monopolistic Competition Vs erfect Competition The quantity sold will be less under monopolistic competition than perfect competition. The prices will be higher under monopolistic competition than under perfect competition. This is because as the firms gain some market power through price differentiation. The consumer benefits from a high quantity of differentiated goods but will be at a disadvantage with respect to price. Monopolistic Vs erfect Competition: Long Run Equilibrium MC C D LR (C) D LR (MC) MC C The diagram above shows the long run average cost curve and the demand under monopolistic and perfect competition. As the monopolistic firm has the ability to set price and faces a downward sloping demand curve they will have set output lower than under perfect competition. This is essentially the reason that monopolistic competition is marginally inefficient compared to perfect competition. Monopolistic Competition Vs Monopoly Monopolistic competition has freedom of entry unlike the monopoly which has extremely high barriers to entry. However the monopoly can sustain super profits in the long run while the monopolistic is susceptible to increased competition. In the long run the monopolistic firm will not earn super normal profits because as new firms enter and supply increases the price will drop and profit will return to their normal levels. Therefore the degree of freedom to enter and exit the monopolistic is the major difference between the monopoly and the monopolistic firm. The monopolistic firm and the monopoly both have downward sloping demand curves, however the monopoly's demand curve is relatively inelastic in the short and long run, while the monopolistic firm's demand curve is relatively elastic in the long run. In the following diagrams we look at the short run and long run equilibrium for both markets. In the short run there is not much difference between the two markets. In the long run the equilibrium of the monopoly remains unchanged, while for the monopolistic firm the demand curve has shifted downwards and become more elastic as the super normal profits become normal profits. This results in a lower prices and higher quantity which resembles higher competition in the market in the long run. 3

4 Short Run Equilibrium: Monopolistic Firm Vs Monopoly SR AC SR SR SRMR AR SR=DS R SR SR MR Monopolistic Firm Monopoly Long Run Equilibrium: Monopolistic Firm Vs Monopoly LR LR AR LR=D LR AR LR=D LR LR Monopolistic Firm LR Monopoly It is worth noting that the monopoly does not face short run or long run curves, as the conditions over both time frames remain the same. However in reality most monopolies do face changing market dynamics so there will be changes but we assume they do not for our purposes. We include both short and long run notation for the monopoly in the diagrams to provide some intuition. Some Issues with Monopolistic Competition Information is not perfect in this market and firms will not enter the market if they are not aware of the level of profits available. When all the firms produce a slightly different version of the good it will make it hard to derive an industry demand curve and the analysis of this demand curve will be quite problematic to interpret. Firms that produce differentiated goods often have different firm size and different cost curves. 4

5 Non price competition (advertising, product development and packaging) is an important part of monopolistic competition because firms will have to decide how much they differentiate their product and how they market it to the consumers. Comparison to other Market Structures Characteristic erfect Competition Monopolistic Oligopoly Monopoly Number of Firms infinite many few one Barriers to Entry none low high very high ricing ower none price setter price setter price setter Elasticity of Demand erfect elasticity relatively elastic (LR) relatively inelastic highly inelastic Ability to earn excess profit none Yes (SR) Yes Yes rofit maximisng condition =MC=MR MR=MC MR=MC MR=MC Market power none low high very high 5

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

MBA 640 Survey of Microeconomics Fall 2006, Quiz 6 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) A monopoly is best defined as a firm that