Monopolistic Competition:

Monopolistic competition is a market structure characterized by a large number of relatively small firms. While the goods produced by the firms in the industry are similar, slight differences often exist. As such, firms operating in monopolistic competition are extremely competitive but each has a small degree of market control. In effect, monopolistic competition is something of a hybrid between perfect competition and monopoly. Comparable to perfect competition, monopolistic competition contains a large number of extremely competitive firms. However, comparable to monopoly, each firm has market control and faces a negatively-sloped demand curve',500,400)">demand curve. The real world is widely populated by monopolistic competition. Perhaps half of the economy's total production comes from monopolistically competitive firms. The best examples of monopolistic competition come from retail trade, including restaurants, clothing stores, and convenience stores.

Characteristics
The four characteristics of monopolistic competition are: (1) large number of small firms, (2) similar, but not identical products, (3) relatively good, but not perfect resource mobility, and (4) extensive, but not perfect knowledge. Large Number of Small Firms: A monopolistically competitive industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that all firms are relatively competitive with very little market control over price or quantity. In particular, each firm has hundreds or even thousands of potential competitors. Similar Products: Each firm in a monopolistically competitive market sells a similar, but not absolutely identical, product. The goods sold by the firms are close substitutes for one another, just not perfect substitutes. Most important, each good satisfies the same basic want or need. The goods might have subtle but actual physical differences or they might only be perceived different by the buyers. Whatever the reason, buyers treat the goods as similar, but different. Relative Resource Mobility: Monopolistically competitive firms are relatively free to enter and exit an industry. There might be a few restrictions, but not many. These firms are not "perfectly" mobile as with perfect competition, but they are largely unrestricted by government rules and regulations, start-up cost, or other substantial barriers to entry. Extensive Knowledge: In monopolistic competition, buyers do not know everything, but they have relatively complete information about alternative prices. They also have relatively complete information

about product differences, brand names, etc. Each seller also has relatively complete information about production techniques and the prices charged by their competitors.

Market Structure of Monopolistic Competition: Product Differentiation

The goods produced by firms operating in a monopolistically competitive market are subject to product differentiation. The goods are essentially the same, but they have slight differences. Product differentiation is usually achieved in one of three ways: (1) physical differences, (2) perceived differences, and (3) support services. Physical Differences: In some cases the product of one firm is physically different form the product of other firms. One good is chocolate, the other is vanilla. One good uses plastic, the other aluminum. Perceived Differences: In other cases goods are only perceived to be different by the buyers, even though no physical differences exist. Such differences are often created by brand names, where the only difference is the packaging. Support Services: In still other cases, products that are physically identical and perceived to be identical are differentiated by support services. Even though the products purchased are identical, one retail store might offer "service with a smile," while another provides express checkout.Product differentiation is the primary reason that each firm operating in a monopolistically competitive market is able to create a little monopoly all to itself.

Demand and Revenue

The four characteristics of monopolistic competition mean that a monopolistically competitive firm faces a relatively elastic, but not perfectly elastic, demand curve, such as the one displayed in the exhibit to the right. Each firm in a monopolistically competitive market can sell a wide range of output within a relatively narrow range of prices. Demand is relatively elastic in monopolistic competition because each firm faces competition from a large number of very, very close substitutes. However, demand is not perfectly elastic (as in perfect competition) because the output of each firm is slightly different from that of other firms. Monopolistically competitive goods are close substitutes, but not perfect substitutes. In the exhibit to the right, the monopolistically competitive firm can sell up to 10 units of output within the range of $5.50 to $6.50. Should the price go higher than $6.50, the quantity demanded drops to zero. A monopolistically competitive firm is a price maker, with some degree of control over price. Once again, unlike perfect competition, a monopolistically competitive firm has the ability to raise or lower

the price a little, not much, but a little. And like monopoly, the price received by a monopolistically competitive firm (which is also the firm's average revenue) is greater than its marginal revenue. In the exhibit to the right, the marginal revenue curve (MR) lies below the demand/average revenue curve (D = AR). While marginal revenue is less than price, because demand is relatively elastic, the difference tends to be relatively small. For example, 5 units of output correspond to a $5 price. The marginal revenue for the fifth unit is $4.80, less than price, but not by much.

Demand Curve,Monopolistic competition

Short-Run Production
The analysis of short-run production by a monopolistically competitive firm provides insight into market supply. The key assumption is that a monopolistically competitive firm, like any other firm, is motivated by profit maximization. The firm chooses to produce the quantity of output that generates the highest possible level of profit, given price, market demand, cost conditions, production technology, etc. The short-run production decision for monopolistic competition can be illustrated using the exhibit to the right. The top panel indicates the two sides of the profit decision--revenue and cost. The slightly curved green line is total revenue. Because price depends on quantity, the total revenue curve is not a straight line. The curved red line is total cost. The difference between total revenue and total cost is profit, which is illustrated in the lower panel as the brown line. A firm maximizes profit by selecting the quantity of output that generates the greatest gap between the total revenue line and the total cost line in the upper panel, or at the peak of the profit curve in the lower panel. In this example, the profit maximizing output quantity is 6. Any other level of production generates less profit.

Short run production,Monopolistic competition

Long-Run Production
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 the industry. 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 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.

Real World (In)Efficiency

A monopolistically competitive firm generally produces less output and charges a higher price than would be the case for a perfectly competitive industry. In particular, the price charged by a monopolistically competitive firm is greater than its marginal cost. The inequality of price and marginal cost violates the key condition for efficiency. Resources are NOT being used to generate the highest possible level of satisfaction. The reason for this inefficiency is found with market control. Because a monopolistically competitive firm has control over a small slice of the market, it faces a negatively-sloped demand curve and price is greater than marginal revenue, which is set equal to marginal cost when maximizing profit. While monopolistic competition is technically inefficient, it tends to be less inefficient than other market structures, especially monopoly. Even though price is greater than marginal revenue (and thus marginal cost), because the demand curve is relatively elastic, the difference is often relatively small. For example, a monopoly that charges a $100 price while incurring a marginal cost of $20 creates a serious inefficiency problem. In contrast, the inefficiency created by a monopolistically competitive firm that charges a $50 price while incurring a marginal cost of $49.95 is substantially less. The closer marginal revenue is to price, the closer a monopolistically competitive firm comes to allocating resources according to the efficiency benchmark established by perfect competition. In the grand scheme of economic problems, the inefficiency created by monopolistic competition seldom warrants much attention... and deservedly

Monopolistic competition in managerial decisions:

Implication of Product Differentiation: Advertising Decisions As mentioned above, monopolistically competitive firms differentiate their products in order to have some control over the price. In this case, the products are not perfect substitutes, and this makes the demand less than perfectly elastic. The implication of this is that some consumer wont switch when the prices go up within a limit, while others are willing to switch. To keep the other consumers from switching to the substitutes, firms under monopolistic competition spend a lot of money on advertising. There are two kinds of advertising under monopolistic competition. 1) Comparative Advertising: This involves campaigns designed to differentiate a given firms brand from brands sold by competing firms. Comparative advertising is common in the fastfood industry, where firms such as McDonalds attempt to simulate demand for their hamburgers by differentiating them from competing brands. This may induce consumers to pay a premium for a particular brand. This additional value for a brand in the price is called brand equity. 2) Niche Marketing: Firms under monopolistic competition frequently introduce new products. The products could be totally new or new improved. Firms can also advertise a product that fills special needs in the market. This advertising strategy targets a special group of consumers. For example green marketing advertise environmentally friendly products to target the segment of the society that is concerned with the environment. The firm packages a product with materials that are recyclable.

These advertising strategies can bring positive profits in the shortrun. In the longrun other firms will mimic their strategy and reduce profits to zero.

Optimal Advertising Decisions Optimal advertising is determined by the following formula Formula: The profit maximizing advertising-to-sales ratio. A/R = [(EQ, A) / - (EQ, P)] > 0,

where A is expenditure on advertising and R is sales revenue. Note: A/R is a positive fraction because (EQ, P) is already negative and multiplied by a minus). EQ, A = %Q / %A = (Q / A)*(A/Q) is advertising elasticity of demand, and

EQ, P = %Q / %P = (Q / P)*(P / Q), is the ownprice direct elasticity of demand, which is negative.

If EQ, P = - (demand is perfectly price elastic under perfect competition), then A/R = 0. That is, the optimal advertising-to-sales ratio is zero for the perfectly competitive firm. The more elastic the demand with respect to own price (i.e., products are less differentiated and more substitutable), the lower the optimal advertising-to-sales ratio. This is a case of more competition than less, and there is not much need for advertising. The more elastic the demand with respect to advertising, the higher the optimal advertising- tosales ratio.