Chapter 16: Monopolistic Competetion

Rjabec Viktoria
Economics I.
Seminar group number 5
1094 words
Imperfect competetion is something that exist between perfect competetion and monopoly. It
mainly posseses two types, so called oligopoly and monopolistic competetion. In this essay, I
will give a brief overview of how monopolistic competetion is structured, and how it
functionates. Its’ market structure combines elements of monopoly and perfect competetion,
so mainly those which are found in oligopoly as well. In what it differes from an oligopoly, is
the fact that there are many sellers, but each one of them offers a different products, even if
there a slight differentation from what the others have as an offer on the market. Participants
can also choose freely either to enter or exit the market, without any kind of restriction,
because the number of the firms being in the market keeps adjusting as long as economic
profit is driven towards zero.

To start, lets have an insight in product differentation. These firms are not considered price
takers, rather price makers, because they each sell a different product on the market. They
decide on the products worth and how much would they possible sell it for, in order to
maximize profit. These differences that occur in the list of products, leads to a downward
slopping demand curve. Their decision is based on the so called monopolist’s rule, which is
where they decide to produce at a quantity where the marginal cost is equavalent to the
marginal revenue, and take a look at the demand curve where the line at which the marginal
cost binds the marginal revenue and decide on that price which they can sell that specific
quantity definied by the binding. This is where they can react profit maximization. By
examining this we can confidently say that, in the short-run a monopolistic competetion
follows the rules and behaviors of a monopoly, this is why they are seen very similar. They
make profit if the demand curve is placed above the average total cost. As an opposition to
this the firm fights a loss if the average total cost is above the demand curve.

Secondly, we should take a look at the long-run equilibrium version. Even if a firm is making
max profit in the short-run, other competitors are wanting to enter the market, because of the
profit, which leads to an increase in production, and the consumers opportunities to choose
from are widening, resulting in decrease in demand of each firms product. This is not
beneficial for the firms and companies that already exist in the market, because it results them
in loss, which drives them to leave the market. As for buyers the more firms there are the
more products are there to choose from, which can add up a lot to their well-being because
they can optimize their purcahse as much as they want to. However, by losses firms and
companies want to leave the market, this result in a drop of production, but an increase in
demand for the other companies. In this case consumers have less opportunities to choose
from. This never ending cycle of firms entering and exiting the market continues up until
there is exactly zero economics profit in the market. Here, the demand and average total cost
curve are tangent to each other but not crossed.This point is also exist where the marginal
revenue equals the marginal cost. This is where the profit maxinization is reached, leading to
exactly zero economic profit is earned by each individual firm on the market in the long-run.

Mainly two charasteristic are described when we talk about the long-run equilibrium. The
first is in the case of monopolistic market, if the price is greater than the marginal cost, that is
when the firm is making profit, but the key element which is the marginal cost and marginal
revenue should equal. This makes the marginal revenue less than the set price, because the
demand curve as I previously mentioned is donward slopping. The second case occurs in the
competetive market, so if the price equals average total cost it result in free entry and exit, but
the economic profit remains zero.

Thirdly, we should go over the main differencences between monopolistic competetion and
perfect competetion. The two main differences are excess capacity and markup over marginal
cost. Firms tend to have excess capacity, which is when they produce at not the minimum
average total cost, when they are a part of monopolistic competetion. Meaning that as a
contrast to perfect competetion they can increase the quantity ouput with a low average total
cost of production compared to perfect competetion. Markup, represent the relationship
between the price and the marginal cost, in a monopolistic competetion, the price exceds
marginal cost, because the firm is able to hold somesort of market power. In perfect
competetion they produce the quantity at the minimum of average total cost which is called
the efficient scale. Here, the markup price euqals the marginal cost.

Another point that needs to be mentioned, is the welfare of society. When a newly developed
firm decides to enter the market, it has two effects. One is the production-variety externally,
meaning that consumers get some surplus from the new product introduced, it has a positive
impact externally on the buyers. The second is the business-stealing externally, which is that
already existing firms lose buyers because the entered firm introduces other oiptions,
resulting in a negative effect externally in the owners.
Lastly, advertisament has a big role when it comes to the market, and has been a debate topic
eversince. Firms are wanting to advertise in order to use it as an incentive to consumers. Even
so, advertising calls for a high input. Companies spend 10-20% of revenue to advertize highly
differentiated goods. They mainly use it to manipulate people’s tastes and to catch their
attention. It is highly debated because it is more psychological than informational, it creates a
desire in consumers that otherwise would not exists. It also impedes competetion, this is why
other firms also need to participate in advertising in order to get recognized by buyers.

To sum it all up, when we talk about monopolistic competetion, we talk about a market
structure where there are numerous firms, producing different products leading to a blend of
not only monopolistic but also competetion features. Each firm holds market power because
of the differences. However, they face the challenges of the continous cycle of the entry and
exit of other firms. It showcases the differentation in a dynamic market.