PAUL YUNREED WILSON

Monopolistic Competition

Characteristics

There are 3 Characteristics of Monopolistic Competition

(1) A relatively large number of sellers

(2) Differentiated products

(3) Easy Entry to, and exit from, the industry

The first and third point provides the “competitive” aspect of monopolistic competition, and the second the “monopolistic” aspect. However, monopolistic competitive industries are generally more competitive than they are monopolistic.

Relatively Large Number of Sellers

Characterized by a fairly large number of firms, typically around 2 digits in number, not in the hundreds or thousands of pure-competition.

Small Market Shares – Each firm holds only a small percentage of the total market, therefore a limited amount of control over market price

No Collusion – The large number of firms guarantees that collaboration between firms to restrict output and set prices is unlikely

Independent Action – Each firm chooses their own price without taking into account other firms’ decisions. Cutting or increasing price will not trigger a competitor to change its prices also.

Differentiated Products

There is product differentiation between firms, in other words, each firm produces a product that is similar to the next, but also has minor differences that distinguish it from others. The aspects include:

Product Attributes

Service

Location

Brand Name and Packaging

Some Control over Price

Advertising

Product Attributes

Differences in functional features, materials, design, and workmanship are the main characteristics of product differentiation.

Example – Smartphones(iPhone 6, SGS6, Nexus 6)

Service

The different types of service and the conditions surrounding the sale of a product affects a consumer’s choice in product and product differentiation

Example – (Best Buy, Amazon, Generic Store)

Location

The Location of a product sold greatly differentiates from other competitors, as one store may be closer to a group of consumers than another

Brand Names and Packaging

While the actual good may be almost identical to another, the brand names, trademarks, packaging, and celebrity connections may change consumer preferences.

Some Control Over Price

Even with the large amount of competing firms, monopolistic competitors have some control of the product’s price due to product differentiation. A consumer who has a preference for one particular product over the rest may pay a small amount more in order to get it.

Advertising

The differences in identical products would be meaningless unless a firm goes out of its way to present them in a favorable light. The goal of product differentiation and advertising, or nonprice competition – is to make price less of a factor and the product differences greater of a factor.

Easy Entry and Exit

Compared to an oligopoly or pure monopoly, monopolistic competitive industries are relatively easy to enter due to them being typically small firms. The economies of scale are few and capital required is low.

Financial barriers may result from the need to develop a product that is different from the competitors. Some firms use patents and copyrights on their brand names to make it hard for other firms to imitate them.

Exit is extremely east for a monopolistic competitive firm, as there is nothing that prevents an unprofitable firm from holding a clearance sale and shutting down.

Graphical Representation

Industry % of Industry output produced by the Four Largest Firms

Herfindahl Index

Industry % of Industry Output Produced by the Four Largest Firms

Herfindahl Index

Manufactured Ice 24 264 Textile Bags 17 164

Plastic Pipe 23 268 Bolts, nuts, and rivets

17 134

Book Publishing 23 251 Jewelry 16 95

Paperboard Boxes 23 237 Typesetting 16 106

Curtains and Draperies

22 184 Asphalt Paving 15 103

Textile machinery 21 197 Sawmills 14 78

Leather goods 21 196 Women’s Dresses 11 61

Lighting fixtures 21 191 Sheet Metal Work 9 34

Wood Furniture 20 167 Wood pallets 6 14

WoodKitchen Cabinets

19 156

Demand Curve – Why?

The basic feature of the diagram shown prior is the elasticity of demand, as seen by the individual firm’s demand curve. This curve is almost perfectly elastic, a feature that distinguishes itself from other types of markets.

Compared to a pure monopolist, a monopolistic competitive seller has many people selling almost identical goods, while a pure monopolist has none besides itself, thus is more elastic.

It is not perfectly elastic like a perfectly competitive market due to (1)a monopolistic competitor has fewer rivals, and (2) the products have some differences, so they are not perfect substitutes.

Short Run vs. Long Run

Price and costs

Quantity Quantit

y

Quantity

Price and costs

Price and costs

MC ATC

D1

MRMR = MC

Economic Profit

(1)Short-Run Profits

(3)Long-Run Equilibrium

(2)Short-Run Losses

MR

D2

ATCMC

MR = MC

Economic Loss

D3

ATCMC

MR = MC

PA

AP

P=A

Short Run vs. Long Run Explanation

Just like prior markets studied, by producing output at which MR = MC, a monopolistically competitive firm maximizes its profits or minimizes it losses in the short run. If demand, or price, is greater than ATC at this point, than a profit is gained as seen in the graph 1. If demand is less than ATC at this point, there is a loss as seen in graph 2.

In the long run, firms enter a profitable monopolistically competitive industry and leave unprofitable ones. Therefore, a firm will earn only a normal profit in the long run.(In others words only break even, as seen in graph 3)

Monopolistic Competition and Efficiency

D3

ATCMC

MR = MC

P3=A3

Long-Run Equilibrium

Price and costs

Quantity

MR = MC

MC

ATC

D3

P3=A3

A4

M3

Q3 Q4

Monopolistic Competition and Efficiency Explained

From previous chapters, we learned that economic efficiency requires that P=MC=minimum ATC.

The equality of price and minimum average total cost yields productive efficiency. The product is produced the least costly way, and the price is enough to cover the cost of producing the cost, including normal profit.

The equality of price and marginal cost yields allocative efficiency. The right quantity is being produced, thus the right amount of scarce resources are being allocated for this specific use.

• HOWEVER, In Monopolistic Competition, neither productive nor allocative efficiency occurs in long-run equilibrium. As seen the from the graph prior, the profit-maximizing P3 price is slightly greater than the lowest ATC, A4. Thus, in producing at Q3, the profit-maximizing point, the ATC is higher than optimal from productive efficiency. Also, P3 is greater than the MC at Q3.

• Consumers thus pay higher-than-competitive price and obtain a less-than-optimal output.

• This gap between the minimum-ATC output and profit-maximizing output shows the excess capacity: factories and equipment are underused because firms are producing less than the minimum-ATC output, meaning that fewer firms could produce the same output in the ideal situation. Monopolistically competitive firms thus are overcrowded with firms, each operating below its optimal capacity.

Understanding Product Variety

In an attempt to stay at an advantage from competitors, firms attempt to be as innovative as possible with their product through further product differentiation and better advertising. By doing so, a firm is able to stall the looming outcome of Graph 3.

The drive to be different can offset the cost of inefficiency regarding monopolistic competition. Consumers are thus offered a wide variety of the same type of product, a noticeable improvement than simply pure competition that has only one product.

This strive for product improvement also forces competitors to continuously improve their own products in order to not lose customers to others.

The more product differentiation, the greater excess capacity, thus the greater productive inefficiency. However, the greater the product differentiation, the more diversity a consumer has in choosing a product.

Final Thoughts

The ability to change consumer demand for a specific product without changing price makes the monopolistic competition more complex than others.

A monopolistic competitive firm must place careful analysis on the 3 factors – price, product, and advertising to seek the maximum profit.

Therefore, it is forced to determine what variety, selling price, and advertising level would be optimal for the greatest profit.

This complex situation cannot easily be solved using simply graphs; instead, it requires trial and error to find that certain combination.