MONOPOLISTIC COMPETITIONCHAPTER 10 – ECONOMICS – A COURSE COMPANIONBlink & Dorton, 2007. p114-118

Introduction to Monopolistic Competition

• The theory of monopolistic competition was developed by the American Economist Edward Chamberlin (1899-1967).

• He was dissatisfied with two extreme theories that existed at the time – perfect competition and monopoly.

• He wanted to devise something more realistic that would sit between the two existing theories.

What is monopolistically competitive market?

• In simple terms a monopolistically competitive market is one with many competing firms where each firm has a little bit of market part.

• This is why we have the term “monopolistic” as firms have some ability to set their own prices.

The assumptions of monopolistic competition

• The industry is made up of a fairly large number of firms.

• The firms are small, relative to the size of the industry. This means that the action of one firm are unlikely to great effect on any of its competitors.

• However, they have some control over price.• The firms assume that they are able to act

independently of each other.

The assumptions of monopolistic competition

• The firms all produce slightly differentiated products.

• This means that is possible for a consumer to tell one firm’s product from another.

• Firms are completely free to enter or leave the industry. There are no barriers to entry or exist.

How is Monopolistic Competition different to Perfect Competition ?

• The major difference from perfect competition, is that in monopolistic competition, there is product differentiation.

• In addition, consumers do have perfect information. • Product differentiation exists when a good or service

is perceived to be different from other goods or services in some way.

• Products may be differentiated by brand name, colour, appearance, packaging design, quality of service, skill levels and many other methods.

Examples of Monopolistically Competitive Industries

• Examples of monopolistically competitive industries are car mechanics, plumbers and jewellers.

How is the market structure different?

• Although it may appear to be a small difference from the assumptions of perfect competition, this leads to a markedly different market structure.

• As the products are differentiated there will some extent of brand loyalty.

Brand Loyalty

• Some consumers will be loyal to the product and continue to buy it if the price goes up little.

• For example, if my that a customer of a certain plumber will stay with that plumber, when he raises prices above local rivals, because they believe he is slightly more skilled his competitors.

Brand Loyalty & Price

• Brand loyalty means that producers have some element of independence when they are deciding on price.

• They are, to an extent, price makers, and so they faced a downward sloping demand curve.

• However, demand will be relatively elastic since there are many, only slightly different substitutes.

DEMAND CURVE – MONOPOLISTIC COMPETITION

The firm faces a downward sloping demand curve with a marginal revenue curve that is below it. It produces so that it is maximising profits where MC=MR. This means that the firm will produce an output of q and sell that output at a price of P.

SHORT RUN ABNORMAL PROFITS IN MONOPOLISTIC COMPETITION

In this case, the firm is maximising profits by producing at the level of output where MC=MR, and the cost per unit (AC) of C is less than the selling price of P. There is an abnormal profit that is shown by the shaded area.

SHORT RUN ABNORMAL LOSSES IN MONOPOLISTIC COMPETITION

Once again, in this diagram the firm is producing where MC=MR, but this this time the cost per unit, C, is above the price, P, and the amount of losses is shown by the shaded areas.

Long Run Equilibrium of the firm in Monopolistic Competition

• Regardless of abnormal profits or losses, there will be long run equilibrium where all the firms in the industry are making normal profits. This is because there is freedom of entry and exit in the industry.

Long Run Equilibrium of the firm in Monopolistic Competition

Abnormal Profits attract new Entrants• If the firms are making short-run abnormal

profits, then other firms will be attracted to the industry.

• Since there are no barriers to entry it is possible for other firms to join the industry.

• As they enter they will take business away from existing firms whose demand curve will start to shift to the left.

Long Run Equilibrium of the firm in Monopolistic Competition

Losses leads to firms exiting the industry• If firms are making short run losses, then

some of the firms in the industry will start to leave.

• The firms that remain will find that their demand curves start to shift to the right as they pick up trade from the leaving firms.

Long Run Equilibrium of the firm in Monopolistic Competition

Product Differentiation • When new entrants come into the market,

they will try to distinguish themselves, in a number of ways.

• This production differentiation is also know as non-price competition.

LONG RUN EQUILIBIRUM IN MONOPOLISTIC COMPETITION

All firms are making normal profits. The firms are maximising profits by producing at level of output where MC = MR and, at that output, the cost per unit, C, is equal to the price per unit, P. Each firm is exactly covering its costs, including opportunity costs, and so there is no incentive for firms to leave the industry. Firms outside the industry will not enter, since they will be aware that their entrance would lead to losses for everyone.

RESTUARANT EXAMPLE OF MONOPOLISTIC COMEPTITION

PRODUCTIVE & ALLOCATIVE EFFICIENCY IN MONOPOLISTIC COMPETITION

• Productive efficiency is achieved at the level of output where a firm produces at the lowest possible cost per unit, the point where AC is at a minimum. This is the point where MC curve cuts the AC curve.

• Allocative Efficiency is achieved at the level of output where the MC curve cuts the AR curve: the social optimum level of output.

PRODUCTIVE AND ALLOCATIVE EFFICENCY IN THE SHORT RUN IN MONOPOLISTIC COMPETITION

The graphs above show two possible short run positions in monopolistic competition and abnormal profits and losses. The firm produces at the level of output where profits are maximised, q, as opposed to the productively efficient level of output q1 or the allocatively efficient level of output, q2.

PRODUCTIVE AND ALLOCATIVE EFFICENCY IN THE LONG RUN

The firm is again producing at the profit-maximising level of output, q, and not at the productively efficient level of output, q1 or the allocatively efficient level of output q2.

Monopolistic Competition in comparison with Perfect Competition

• Unlike perfect competition, where in the long run the firms are profit-maximisers, productively efficient and allocatively efficient, firms in monopolistic competition, are neither productively or allocatively efficient.

• Firms in monopolistic competition in the long run are maximising profit only.

Why is productive and allocatively efficiency not achieved with Monopolistic Competition?

• Even though the firm is monopolistic competition is not allocatively efficient (it does not produce where MC=AR) and is not productively efficient (it does not produce where MC=AC) the inefficiency is not due to the firm’s ability to restrict output and increase price as in a monopoly.

• The inefficiency is, in fact, the result of the consumers desire for variety

Why is productive and allocatively efficiency not achieved with Monopolistic Competition?

• Although allocative efficiency does not occur, it is hard to argue that consumers are worse off with monopolistic competition than with perfect competition, since the difference is due entirely to consumer desire to have differentiated products.

Price & Monopolistic Competition

• Rather than having a perfectly competitive situation, where consumers pay lower prices, but are able to purchase a homogenous product, monopolistic competition give consumers the opportunity to make choices.

• This is why they are prepared to pay slightly higher prices for the products.

EXAMINATION QUESTIONS Short Response Questions

1. With the help of a diagram, explain the level of output that a profit-maximising firm will produce at in the long run in monopolistic competition. (10 marks)

2. With the help of a diagram, explain how it is possible for a firm in monopolistic competition to earn abnormal profits in the short run.

3. Explain whether or not a firm in monopolist competition earning abnormal profits is productively and allocatively efficient.

EXAMINATION QUESTIONS Essay Questions

1a. Explain the differences between the assumptions of perfect competition and monopolistic competition.1b. Evaluate the view that it would be beneficial if all markets were in perfect competition.