MONOPOLISTIC COMPETITION

Wk 8 2014

Syllabus Outcomes Covered • Describe, using examples, the assumed characteristics of a

monopolistic competition• Explain that product differentiation leads to a small degree of

monopoly power and therefore to a negatively sloping demand curve for the product.

• Explain, using a diagram, the short-run equilibrium output and pricing decisions of a profit maximizing (loss minimizing) firm in monopolistic competition, identifying the firm’s economic

profit (or loss)• Explain, using diagrams, why in the long run a firm in

monopolistic competition will make normal profit• Distinguish between price competition and non-price

competition • Explain, using a diagram, why neither allocative efficiency nor

productive efficiency are achieved by monopolistically competitive firms

Assumptions of the model1. large no of firms - similar to PC

2. No barriers to entry/ exit - similar to PC

3. product differentiation – different to PC

Product differentiationPhysical differences – shape, size,

materials ( eg: clothing, books, furniture, food)

Quality differences – eg: cars / electronics

Location – establishing businesses in locations with easy access to customers / suppliers eg: hotels near airports, convenience stores near residential houses

Product differentiationServices – by offering special

services with purchases eg: warranties and service on cars

Product image – creating favourable image using advertising or celebrity endorsement – eg: Nestle, Nike

Product differentiation and Monopolistic demand and revenue curves

Monopolistic market structures have elements of monopoly and perfect competition.

Similar to P.C due to large no of firms and no barriers to entry /exit and

Similar to monopoly due to product differentiation leading to higher P being set.

Examples Nike , Adidas, Puma are all part

of many firms that make sports goods and shoes

However each one of these firms has its own monopoly power related to its own products

Monopolistic Firms and PricingUnder P.C if firms raise P – it loses

all salesUnder Monopoly if firms raise P –

it loses some sales Why????Under Monopolistic firms if P rise

– it loses more sales than monopoly – due to available substitutes but less than P.C due to product differentiation

ImplicationsThe way consumers behave in

response to P rise under monopolistic competition has important implication for monopolistic firms because if firms can convince their consumers that their product is better than competitors then they will be able to gain monopoly power and charge higher P without losing sales.

Shape of D curve

D

D

D

Perfect Competition

Monopoly

Monopolistic

Role of P and Non P competition

P competition: occurs when forms lowers P to attract customers away from rivals increasing its sales at expense of rivals

Non P competition: occurs when firms use methods other than P to attract customers eg: advertising, quality, product support etc

Monopolistic firms invest in R& D and advertising to differentiate their product and improve it all the time because it gives them monopoly power.

Rule: the more differentiated is a product from its substitute and the more successful are the advertising strategies the less elastic (or more inelastic) will D curve be and the greater is the firm monopoly power and profits gains earned in SR only

Profit maximization SR position identical to monopoly

– only difference being PED of D curve facing these firms.

D curve is flatter and more elastic than monopoly

In SR firms can make either supernormal profits (+ve profits), normal profits(0 profits) or losses (-ve profits)

Firms apply rule of MR+MC to find profit max o/p

extend to demand curve to find P Compare P with ATC to determine

profits or losses per unit.In part (a) of 7.21 firms earn

supernormal profits since P>ATC In part (b) P =ATC = normal

profits In part (c) P< ATC = losses

Total profits or losses calculated by:

Profits = Profits/Q X QLosses = Losses/Q XQ

Profits in the LRJust like PC – in monopolistic

firms in LR profits attracts new firms into industry and eliminate profits and firms earn normal profits

Firms losing will exist industry and losses will be eliminated too back to normal profits

The Profitable IndustryFirms making profits will attract

new firms into the industry who will produce at lower prices and therefore more customers will attract customers away from existing (more expensive) firms.

The impact on existing firms will be a shift in D curve to left and keeps shifting left with more firms entering until D is tangent(touches) ATC

The unprofitable industryFirms making losses lead firms to exit

the industry. Customers therefore switch to the available substitutes which now experience rise in D

The impact on the remaining firms will be a shift in D curve to the right. The process continues until all loses disappear when D is tangent(touches) ATC and firms earn normal profits.

This occurs where MR = MC and P= ATC

Efficiency in Monopolistic competition

Remembering the rule: Allocative efficiency when P=MCProductive efficiency when

production takes place with at mini ATC

Efficiency in Monopolistic competition

In the LR – monopolistic firms do not achieve allocative nor productive efficiency

WHY?? Refer to diagram 7.22 slide 19.

Monopolistic competition and allocative efficiency

Allocative efficiency is achieved where

P = MC In LR monopolistic competition

sells at P> MC therefore leads to under

allocation of resources to the production of this good when society would have liked to have more output

Monopolistic competition and productive efficiency

Production also occurs at higher than minimum ATC and therefore average costs are higher than what is optimal from society’s view.

CAPACITY OUTPUTA firm capacity is the

output level where firm capacity is fully used

Full capacity = output where ATC is minimum = Qc

Profit max rule is MR = MC = Qe Qe < Qc

excess capacity

= Capacity o/p – Profit max o/p This is the o/p lost when firm

resources are underused because they produce o/p that does not minimise ATC

If all firms produce at min ATC then same Q of o/p would be produced by less firms at less cost to society.

excess capacity

Excess capacity is the result of product differentiation leading to a downward sloping demand curve for firms.

Excess capacity is closely related to productive inefficiency due to production occurring at > mini ATC

EG: restaurants with empty tablesRetail shops with no customersHotels with empty rooms

Product differentiation leads to product variety

Therefore monopolistic competition may not be as inefficient as it is suggested

Excess capacity is P customers pay having product variety