MIC ECON Lec 06 – Monopolistic Competition

CHAPTER 6:

 MONOPOLISTIC COMPETITION

LEARNING OBJECTIVE The purpose of this topic is to look at a very common form of market where firms are numerous but have some monopoly power. The characteristics of the market are first stated. The short and long run equilibrium is shown. The economic effect of this market is derived. Because of the importance of nonprice action in this market, advertising is given special attention.

MONOPOLISTIC COMPETITION Monopolistic competition is a type of market characterized by – a large number of firms, – products which are differentiated and not seen as perfect substitutes by consumers, – some ability of sellers to set prices as they wish, – free entry to and exit from the market, – heavy reliance on nonprice actions to differentiate one’s product.

The monopolistic competition form of market is extremely common. Almost all retail operations are in this form of market. Small businesses in all sectors fall in this category. Starting a business is relatively easily, but staying in business is not: that requires an ability to convince customers that the product is different and better than that of competitors.

MONOPOLISTIC COMPETITION NUMBER OF FIRMS The large number of firms in monopolistic competition implies that the firms are small in comparison to the entire market. Although they have some power over price (to the extent that their products are differentiated), they do not have sufficient power to retaliate if another firm changes its price. This is the major distinction between this market form and oligopoly.

MONOPOLISTIC COMPETITION DIFFERENTIATED PRODUCT The differentiated product sold by a firm in monopolistic competition has some features that makes a customer prefer it over the available similar products of other firms. The features may be physical or created by advertising. The power of any firm over price stems from this very fact that products are not perfect substitutes. Nonprice actions are necessary to make the products differentiated.

MONOPOLISTIC COMPETITION ENTRY TO MARKET No barriers to entry or exit exist in monopolistic competition. However, the need to make one’s product differentiated may require non price action, which, if unsuccessful, would drive the firm out of the market.

MONOPOLISTIC COMPETITION DEMAND The demand of a firm in monopolistic competition is down sloping because of the preference of customers for the features of the differentiated product. However, because there are many close (if not perfect) substitutes readily available, the demand is highly elastic. Graphically, this means that the demand in monopolistic competition is flatter than in monopoly.

The demand of a restaurant is likely to be very elastic because there are many other food outlets available to customers. But the demand is not perfectly elastic (i.e. horizontal) as in the case of perfect competition because, each restaurant has something to offer other restaurants do not: for instance, convenience, location, elaborate menu, or just atmosphere.

MONOPOLISTIC COMPETITION PROFIT The profit of a firm in monopolistic competition is determined in the same fashion as in any other type of market by finding the optimum quantity where marginal revenue intersects marginal cost. This optimum level of output, in turn, determines the price charged (on the demand curve) and average unit cost (on the average total cost curve). The profit is the excess of total revenue area over total cost area.

A restaurant should accept customers as long as the additional or marginal revenue exceeds the additional or marginal cost of the last meal served. This seems to be apparent in the reservation process which limits the number of patrons. Without reservations, the restaurant would either have to serve customers in overcrowded conditions or make them wait on line.

MONOPOLISTIC COMPETITION LONG RUN EQUILIBRIUM The long run equilibrium of a firm in monopolistic competition is where demand is tangent to the average total cost curve. There is no profit. Should there be a profit (if demand is above the average total cost curve), firms would enter the market and drive the demand down. And should there be a loss (when demand is below average total cost), firms would leave the market and push demand up. Firms may, however, retain some profits by using more nonprice action.

All successful restaurants have scores of imitators. Several chains have attempted to duplicate McDonald, and siphoned some of its customers and profits. But, McDonald has fought back with extensive advertising.

MONOPOLISTIC COMPETITION ECONOMIC EFFECT The economic effect of monopolistic competition is an overall undesirable loss of allocative and productive efficiency: the customer pays more and is able to buy less than in perfect competition. However, the effect is not as serious as in monopoly and the differentiated products provide a much sought diversity. Nevertheless, some waste is present in excess capacity and in use of nonprice competition.

Generic product markets approach perfect competition because they are standardized. Brand name products of the same type (for instance, cookies) are in monopolistic competition because they are not the same uniform item, but somewhat different. Customers have to pay a higher price for brand name products (such as Nabisco or Keebler), but they do not seem to mind too much.

MONOPOLISTIC COMPETITION NONPRICE ACTION Nonprice action of firms in monopolistic competition consists primarily in either – product development, or – advertising. Product development is sometimes only cosmetic to give the illusion of novelty. Another danger stems from excessive diversity which may confuse consumers.

Brand name producers have a variety of means to make their products special to customers. Most important is advertisement which generic item producers would obviously not use.

ADVERTISING – ARGUMENTS IN FAVOR Some of the arguments in favor of advertising are – advertising is informative, – advertising increases sales and permits economies of scale, – advertising increases sales and contributes to economic growth, – advertising supports the media, – advertising increases competition and lowers prices.

New product advertisement is essential: think of a major artistic event that interested viewers would fail to see because it has not been announced widely enough. But, most of the advertisement (on television for instance) is for existing, well-established products such as soft drinks or other consumer products; that advertisement seeks only to sway customers away from competitors.

ADVERTISING – ARGUMENTS AGAINST Some of the arguments against advertising are – advertising is not informative but competitive, – the economies of scale are illusory, – advertising raises the cost curve, – advertisers may use their influence to bias the media, – advertising is used as an entry barrier, and – advertising is not a productive activity.