1.5.

Monopolistic Competition

Monopolistic competition is a type of imperfect competition such that many

producers sell products that are differentiated from one another (e.g. by
branding or quality) and hence are not perfect substitutes.

Monopolistic competition as a market structure was first identified in the 1930s

by American economist Edward Chamberlin, and English economist Joan
Robinson.

Many small businesses operate under conditions of monopolistic competition,

including independently owned and operated high-street stores and restaurants.
In the case of restaurants, each one offers something different and possesses an
element of uniqueness, but all are essentially competing for the same customers.

Monopolistic competition incorporates features of both perfect competition and

monopoly. Monopolistic competition is a market structure in which:

1. A large number of firms compete

2. Each firm produces a differentiated product
3. Firms compete on product quality, price and marketing
4. Barriers to entry exist but are very low
5. Knowledge is widely spread between participants, but it is unlikely to be
perfect. For example, diners can review all the menus available from
restaurants in a town, before they make their choice. Once inside the
restaurant, they can view the menu again, before ordering. However, they
cannot fully appreciate the restaurant or the meal until after they have
dined.
6. 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.
7. Monopolistically competitive firms are assumed to be profit
maximisers because firms tend to be small with entrepreneurs actively
involved in managing the business.

Source:
http://www.economicsonline.co.uk/Business_economics/Monopolistic_competit
ion.html

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Some of assumptions in more detail

1: Large numbers of firms compete.

a) Small market share each firms supplies a small part of the market.
Consequently, although each firm can influence the price of its own
product, it has little power to influence the market average price.
b) No market dominance each firm must be sensitive to the average market
price of the product. But it does not pay attention to any one individual
competitor. Because all the firms are relatively small, no single firm can
dictate market conditions
c) Collusion impossible collusion is impossible when the market has a large
number of firms.

2: Product Differentiation
This is the practice of making a product that is slightly different from the
products of competing firms. A differentiated product has close substitutes but it
does not have perfect substitutes e.g. Adidas, Diadora, Etonic, Fila, Nike, Puma
and Reebok.

3: Firms compete on product quality, price and marketing

Product differentiation enables a firm to compete with other firms in three areas:
quality, price and marketing.

a) Quality the quality of a product is the physical attributes that make it

different from the products of other firms. Quality includes design,
reliability, the service provided to the buyer and the buyers ease of access
to the product. The website http://www.jdpower.com/home.php rates the
quality of many products including automobiles, financial services, travel
and accommodation services.
b) Price because of product differentiation, a firm in monopolistic
competition faces a downward-sloping demand curve. So, like a monopoly,
the firm can set both its price and its output.
c) Marketing because of product differentiation, a firm must market its
product. This is done through advertising and packaging. A firm that
produces a high-quality product wants to sell it for a suitably high price. To
be able to do so, the firm must advertise and package its product in a way
that convinces buyers that they are getting the higher quality for which
they are paying. For example, drug companies advertise and package their
brand-name drugs to persuade buyers that these items are superior to the
lower-priced generic alternatives.

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 4: Entry and Exit in monopolistic competition, there are very low barriers
to entry. Consequently, a firm cannot make an economic profit in the long run.
When firms make economic profits, new firms enter the industry. This entry
lowers prices and eventually eliminates economic profits. When economic
losses are incurred, some firms leave the industry. Exit increases prices and
profits and eventually eliminates the economic losses. In the long-run
equilibrium, firms neither enter nor leave the industry and the firms in the
industry make zero economic profit.

Equilibrium under monopolistic competition

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 price P. Given that price
(AR) is above ATC at Q, supernormal profits are possible.

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Factors for supernormal profits in short run:

- Some market pricing power

- Product differentiation
- Some information asymmetry
- Some barriers of entry
- Brand name (i.e. promotion and advertisement)

As new firms enter the market, demand for the existing firms products
becomes more elastic and the demand curve shifts to the left, driving down
price. Eventually, all super-normal profits are eroded away.

Loss-minimizing quantity

A firm might incur an economic loss in the short run. Here is an example. In this case,
P < ATC.

Long-run equilibrium under Monopolistic Competition

In the long run, because of the absence of entry barriers, new entrants will enter
the market attracted by supernormal profits (SNP). The overall market supply
rises, causing the market price to fall. The demand for the existing firms product

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subsequently falls as its share of the market demand declines, SNP are competed
away with the influx of new firms. Equilibrium in the long run is achieved when
participating firms are making normal profits only. There is no further incentive
for potential firms to enter the market.

Long run equilibrium

In long run, the demand decreases and hence D curve shifts left. The demand also
becomes more elastic.

ATC also increases since the costs increase under fierce competition of different
firms.

However, many other firms may leave the market without the attraction of
supernormal profit in the long run, so that the price goes back up again, ending
up at $50.

As a result, monopolistic competitive firms can earn supernormal profit in the

short run but normal in the long run.

As to maintain market share, the firm needs to: advertise more and promote

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Monopolistic Competition and Inefficiency

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

The monopolistic firm is not producing at the point of full productive capacity
(where MC cuts ATC at point Pe). The firms do not produce at the lowest point on
its average total cost curve. In this regard, monopolistically competitive markets
compare unfavourably to perfectly competitive markets.

Furthermore, on account of product differentiation and the subsequent market

power that exists, price exceeds marginal cost (point of allocative efficiency
occurs Ae where MC = AR).

Part of the explanation for such inefficiencies lie in the fact that advertising,
branding and other forms of product differentiation constitute additional costs to
the firm. The positive aspect of monopolistic competition is the wider product
choice it offers to the consumer. Benefits such as improved quality and service
may also result from non-price competition. Unfortunately, we gain variety at the
expense of efficiency.

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Illustration of mark-up (Price > MC i.e. allocatively inefficient) and excess
capacity (productively inefficient)

Mark-up: extent by which price (MB) exceeds MC (D>MC)

Business Markup= 100%

()
Economics (per unit) = 100%

Why not allocative efficient (MC=AR) and productive efficient(MC=MR)? There is

no incentive for the firm to produce at an allocatively-efficient since it wants to
maximize profit and also avert economic losses.

Excess capacity factories are not fully-utilize so that they lose the opportunity
to benefit from economies of scale

Excesss capacity in example= 25%

Do Product Development and Marketing benefit the consumer?

Product Development and Innovation

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To enjoy economic profits, firms in monopolistic competition must be continually
developing new products. The reason is that whenever economic profits are
earned, imitators emerge and set up business. So to maintain its economic profit,
a firm must seek out new products that will provide it with a competitive edge,
even if temporarily.

Innovation and product development are costly activities but they bring in
additional revenues. The firm must balance the cost and benefit at the margin
(MC=MR).

Monopolistic competition brings to market many improved products that bring

great benefits to the consumer. But many so-called improvements amount to
little more than changing the appearance or giving it a different look to the
packaging.

However, regardless of the opinion above, because price exceeds marginal cost in
monopolistic competition, product innovation is not pushed to its efficient level.

Marketing

Firms in monopolistic competition incur huge costs to ensure that buyers

appreciate and value the differences between their own products and those of
their competitors. Advertising expenditures and other selling costs affect the
profits of firms in two ways. They increase costs and they change demand.

Advertising costs and other selling costs (promotion) are fixed costs. So just like
fixed production costs, advertising costs per unit decrease as production
increases.

If advertising increases the quantity sold by a large enough quantity it can lower
ATC. The reason is that although the total fixed cost has increased, the greater
fixed cost is spread over a greater output so ATC decreases.

Example of advertising and effect on average total cost

Advertising costs might lower the average total cost by increasing equilibrium
output and spreading their fixed costs over the larger quantity produced. Here,

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with no advertising, the firm produces 25 units of output at an average total cost
of $60.

With advertising, the firm produces 100 units of output at an average total cost of
$40. The advertising expenditure shifts the average total cost curve upward, but
the firm operates at a higher output and lower ATC than it would without
advertising.

Advertising might also decrease the markup.

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With no advertising, demand is not very elastic and the markup is large.
Advertising makes demand more elastic, increases the quantity and lowers the
price and markup.

Does it increase or decrease demand?

The most natural answer is that advertising increases demand. By informing

people about the quality of its product or persuading people to switch products,
demand should rise.

But all firms in monopolistic competition advertise. If their advertising campaign

is not seen as successful, it could lower the demand for the individual firms
product.

Questions

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1:

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aii While defining normal profit, describe it in a manner of implicit and explicit
costs

d In the third paragraph, it show competition drives quality product

differentiation

Large amount of choices for consumers

Customer loyalty; intangible asset

Competitors drives efficiency but still allocative-inefficient

Additional cost for advertising

Low investment in R&D so that the product is not innovative

2: Bianca bakes delicious cookies. Her total fixed cost is $40 a day, and her
average variable cost is $1 a bag. Few people know about Biancas Cookies, and
she is maximizing her profit by selling 10 bags a day for $5 a bag. Bianca thinks
that of she spends $50 a day on advertising she can increase her market and sell
25 bags a day for $5 a bag.

a) If Biancas belief about the effect of advertising is correct, can she increase
her economic profit by advertising? The original profit is $0, btu the new
profit is $10; Therefore the profit is maximized
b) If she advertised, would her average total cost increase or decrease at the
quantity produced? The average total cost would decrease

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c) If Biancas belief about the effect of advertising is correct, would she
continue to sell her cookies for $5 a bag, or would she raise or lower her
price? It depends on the demand curve

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