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1.5.monopolistic Competition
1.5.monopolistic Competition
Monopolistic Competition
Source:
http://www.economicsonline.co.uk/Business_economics/Monopolistic_competit
ion.html
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Some of assumptions in more detail
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.
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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.
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.
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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Factors for supernormal profits in short run:
As new firms enter the market, demand for the existing firms 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.
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 firms product
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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.
In long run, the demand decreases and hence D curve shifts left. The demand also
becomes more elastic.
ATC also increases since the costs increase under fierce competition of different
firms.
However, many other firms may leave the market without the attraction of
supernormal profit in the long run, so that the price goes back up again, ending
up at $50.
As to maintain market share, the firm needs to: advertise more and promote
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Monopolistic Competition and Inefficiency
The firm is allocatively and productively inefficient in both the long and short
run.
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.
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.
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Illustration of mark-up (Price > MC i.e. allocatively inefficient) and excess
capacity (productively inefficient)
()
Economics (per unit) = 100%
Excess capacity factories are not fully-utilize so that they lose the opportunity
to benefit from economies of scale
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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).
However, regardless of the opinion above, because price exceeds marginal cost in
monopolistic competition, product innovation is not pushed to its efficient level.
Marketing
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.
Advertising costs might lower the average total cost by increasing equilibrium
output and spreading their fixed costs over the larger quantity produced. Here,
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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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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.
Questions
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1:
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aii While defining normal profit, describe it in a manner of implicit and explicit
costs
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 Biancas 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 Biancas belief about the effect of advertising is correct, can she increase
her economic profit by advertising? The original profit is $0, btu the new
profit is $10; Therefore the profit is maximized
b) If she advertised, would her average total cost increase or decrease at the
quantity produced? The average total cost would decrease
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c) If Biancas 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? It depends on the demand curve
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