20. Monopilistic Competition

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20. Monopolistic Competition ( Imperfect competition)

Learning Outcomes:

Assumptions and features

Price Determination Equilibrium in the Firm

Group Equilibrium in the Long Period

Non-Price competition ( Factor: Quality)

Product Equilibrium

Selling Cost and Monopolistic Competition

Price and output equilibrium under selling cost

Defects and Wastes of Monopolistic competition

Assumption and features of Monopolistic Competition

The model of monopolistic competition describes a common market structure in

which firms have many competitors, but each one sells a slightly different

product.

Features:

Existence of Large number of Firms- Large number of firms mean that

each individual firm contribution to industry is small and there are no

possibilities of collusion.

Each firm makes independent decisions about price and output, based on

its product, its market, and its costs of production.

A central feature of monopolistic competition is that products are

differentiated. There are four main types of differentiation:

Physical product differentiation, where firms use size, design, colour,

shape, performance, and features to make their products different. For

example, consumer electronics can easily be physically differentiated. For

example Toothpaste has many substitutes, but no one can come with the

brand name with Colgate other than the producer of Colgate.

Marketing differentiation, where firms try to differentiate their product by

distinctive packaging and other promotional techniques. For example,

breakfast cereals can easily be differentiated through packaging.


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Human capital differentiation, where the firm creates differences through

the skill of its employees, the level of training received, distinctive

uniforms, and so on.

Differentiation through distribution, including distribution via mail order

or through internet shopping, such as Amazon.com, which differentiatesitself from traditional bookstores by selling online.

Selling Costs; A producer under monopolistic competition has to incur

expenses to popularize his brand. The expenditure involved in selling the

product is called Selling Cost. Most important form is Advertisement cost.

Firms are price makers and are faced with a downward sloping demand

curve. Because each firm makes a unique product, it can charge a higher or

lower price than its rivals. The firm can set its own price and does not have to

take' it from the industry as a whole, though the industry price may be a

guideline, or becomes a constraint. This also means that the demand curve

will slope downwards.

Freedom of entry and exits: There are no barriers as in the case of

Monopoly

Monopolistic competition presupposes that customers have definite

preferences for particular varieties or brand of products. Hence pricing is

not the problem but product differentiation is the problem and competition isnot on prices but on products.

Price Determination

The Price and output determination under monopolistic competition is

governed by the cost and the revenue curves of the firm

The cost curves are governed by the laws of production.

The revenue curves will not be elastic, like in Perfect competition

where it is parallel to x axis and not like monopoly where it is steepingly

falling down. It will be a sloping down curve, neither too steep nor tooflat.

The product is not homogenous, but slightly different. The firm cannot

sell unlimited quantities at the established price as products of other

firms are close substitutes, if not perfect substitutes.

The curve will not be too steep, since any price change, the demand is

more sensitive due to close substitutes being available and the AR

curve is sloping down curve and MR is also sloping down, below the

AR curve.

Equilibrium under monopolistic competition


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In the short run supernormal profits are possible, but in the long run new firms

are attracted into the industry, because of low barriers to entry, good

knowledge and an opportunity to differentiate.

Monopolistic competition in the short run

At profit maximisation, MC =

MR, and output is Q and priceP. Given that price (AR) isabove ATC at Q, supernormalprofits are possible (areaPABC).

As new firms enter themarket, demand for theexisting firms productsbecomes more elastic and thedemand curve (AR curves)shifts to the left, driving downprice. Eventually, all super-normal profits are erodedaway.

Monopolistic competition in the long run ( Group Equilibrium)

Super-normal profits attract in new entrants, which shifts the demand curve forexisting firm to the left. New entrants continue until only normal profit is available. Atthis point, firms have reached their long run equilibrium.

In the long run, with all inputs variable, a monopolistically competitive industry

reaches equilibrium at an output that generates economies of scale or increasing

returns to scale. At this level of output, the negatively-sloped demand curve is

tangent to the negatively-sloped segment of the long run-average cost curve.

This is achieved through a two-fold adjustment process.

The first of the folds is entry and exit of firms into and out of the industry. This

ensures that firms earn zero economic profit and that price is equal to average cost

The second of the folds is the pursuit of profit maximization by each firm in theindustry. This ensures that firms produce the quantity of output that equates marginal

revenue with short-run and long-run marginal cost.

Because a monopolistically competitive firm has some market control and faces a

negatively-sloped demand curve, the end result of this long-run adjustment is two

equilibrium conditions:

MR = MC = LRMC

P = AR = ATC = LRAC


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With marginal revenue equal to marginal cost, each firm is maximizing profit and has

no reason to adjust the quantity of output or factory size. With price equal to average

cost, each firm in the industry is earning only a normal profit. Economic profit is zero

and there are no economic losses, meaning no firm is inclined to enter or exit the

industry.

These conditions are satisfied separately. However, because price is not equal to

marginal revenue, the two equations are not equal (unlike perfect competition). This

further means that monopolistic competition does NOT achieve long-run equilibrium

at the minimum efficient scale of production.

Clearly, the firm benefits most when it is in its short run and will try to stay in theshort run by innovating, and further product differentiation.

Examples of monopolistic competition

Examples of monopolistic competition can be found in every high street.

Monopolistically competitive firms are most common in industries where

differentiation is possible, such as:

The restaurant business

Hotels and pubs

General specialist retailing

Consumer services, such as hairdressing

The survival of small firms

The existence of monopolistic competition partly explains the survival of small firms

in modern economies. The majority of small firms in the real world operate in

markets that could be said to be monopolistically competitive.


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NON-PRICE COMPETITION


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PRODUCT EQUILIBRIUM


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Selling Cost and Monopolistic Competition


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Defects and Wastes of Monopolistic competition

Evaluation

The advantages of monopolistic competition

Monopolistic competition can bring the following advantages:

There are no significant barriers to entry; therefore markets are relatively

contestable.

Differentiation creates diversity, choice and utility. For example, a typical highstreet in any town will have a number of different restaurants from which to choose.

The market is more efficient than monopoly but less efficient than perfect

competition - less allocatively and less productively efficient. However, they may be

dynamically efficient, innovative in terms of new production processes or new

products. For example, retailers often constantly have to develop new ways to

attract and retain local custom.

The disadvantages of monopolistic competition

There are several potential disadvantages associated with monopolisticcompetition, including:


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Some differentiation does not create utility but generates unnecessary waste,

such as excess packaging. Advertising may also be considered wasteful, though

most is informative rather than persuasive.

As the diagram illustrates, assuming profit maximisation, there is allocative

inefficiency in both the long and short run. This is because price is above marginalcost in both cases. In the long run the firm is less allocatively inefficient, but it is still

inefficient.

Inefficiency

The firm is allocatively and productively inefficient in both the long and short run.

There is a tendency forexcess capacity becausefirms can never fully exploit

their fixed factors becausemass production is difficult.This means they areproductively inefficient inboth the long and short run.However, this is may beoutweighed by theadvantages of diversity andchoice.As an economic model ofcompetition, monopolistic

competition is more realisticthan perfect competition -many familiar andcommonplace markets havemany of the characteristicsof this model.

Unemployment- Productive capacity may not be used fulyl and this will result in

unemployment of resources in the economy. Monopolistic competition may

increase national income but will reduce the propensity to consume, without

creating a comparable increase in the desire to invest.


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Excess Capacity:


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This excess capacity is considered to be wasteful under monopolistic competition as

it arises because of irrational consumer preferences. If the buyers preferences are

rational, this excess capacity will be reduced by concentrating in fewer varieties.

Cross Transport: The existence of cross transport is another factor for waste

in monopolistic competition. For example cloth produced at Bangalore will be

sold at Ahmadabad and clothe produced at Ahmadabad will be sold at

Bangalore. Hence cost of cloth will be increased necessarily due to cost of

transport.

Failure of specialisation: The advantage of arising out of specialisation is lost.

The cost advantage can be had only if sales can be expanded.

Advertising: There is lot of waste in competitive advertisement. This lead to

high cost to consumers.

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20. Monopilistic Competition