Monopolistic competition

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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 a form of 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 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.

Contents
[hide]

• 1 Major characteristics
• 2 Product differentiation
• 3 Many firms
• 4 Free entry and exit
• 5 Independent decision making
• 6 Market power
 • 7 Perfect information
• 8 Inefficiency
• 9 Problems
• 10 Examples
• 11 Notes
• 12 See also

• 13 External links

[edit] 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]

[edit] 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.

[edit] 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.

[edit] 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.

[edit] 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.[11] 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.

[edit] 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.[12] Market power also means that an
MC firm faces a downward sloping demand curve. The demand curve is highly elastic
although not "flat".

[edit] Perfect information

Buyers know exactly what goods are being offered, where the goods are being sold, all
differentiating characteristics of the goods, the good's price, whether a firm is making a
profit and if so how much.[13]

Market Structure comparison

Elasticity Profit
Number Market Product Excess Pricing
of Efficiency maximization
of firms power differentiation profits power
demand condition
Perfect Perfectly Price
Infinite None None No Yes[14] P=MR=MC[15]
Competition elastic taker[15]
Monopolistic Many Low Highly High[17] Yes/No No[19] MR=MC[15] Price
 elastic
(Short/Long)
competition (long run) [18] setter[15]
[16]

Absolute
Relatively Price
Monopoly One High (across Yes No MR=MC[15]
inelastic setter[15]
industries)

[edit] 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. An 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.[20]

[edit] Problems

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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.[21]

[edit] 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.

[edit] 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. ^ Colander, David C. Microeconomics 7th ed. Page 283. McGraw-Hill 2008.
11. ^ Colander, David C. Microeconomics 7th ed. Page 283. McGraw-Hill 2008.
12. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 483 Pearson
2008.
13. ^ Goodwin, N, Nelson, J; Ackerman, F & Weissskopf, T: Microeconomics in Context 2d
ed. page 289. Sharpe 2009
14. ^ Ayers, R & Collinge, R: Microeconomics pages 224-25 Pearson 2003
15. ^ a b c d e f Perloff, J: Microeconomics Theory & Applications with Calculus page 445.
Pearson 2008.
16. ^ Ayers, R & Collinge, R: Microeconomics page 280 Pearson 2003
17. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 424 Prentice-Hall 2001.
18. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 425 Prentice-Hall 2001.
19. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 427 Prentice-Hall 2001.
20. ^ 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.
21. ^ Antony Davies & Thomas Cline (2005). "A Consumer Behavior Approach to Modeling
Monopolistic Competition". Journal of Economic Psychology 26: 797–826.
doi:10.1016/j.joep.2005.05.003.

[edit] See also

• 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

[edit] External links