Monopolistic competition

Monopolistic competition is a form of imperfect competition where many competing producers sell products that

are differentiated from one another (that is, the products are substitutes, but, with differences such as branding, are not

exactly alike). In monopolistic competition firms can behave like monopolies in the short-run, including using market power to

generate profit. In the long-run, other firms enter the market and the benefits of differentiation decrease with competition; the

market becomes more like perfect competition where firms cannot gain economic profit. However, in reality, if consumer

rationality/innovativeness is low and heuristics is preferred, monopolistic competition can fall intonatural monopoly, at the

complete absence of government intervention. At the presence of coercive government, monopolistic competition will fall

into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic

competition are often used to model industries. Textbook examples of industries with market structures similar to

monopolistic competition include restaurants,cereal, clothing, shoes, and service industries in large cities. The "founding

father" of the theory of monopolistic competition was Edward Hastings Chamberlin in his pioneering book on the

subject Theory of Monopolistic Competition (1933). Joan Robinson also receives credit as an early pioneer on the concept.

Monopolistically competitive markets have the following characteristics:

 There are many producers and many consumers in a given market, and no business has total control over the

market price.

 Consumers perceive that there are non-price differences among the competitors' products.

 There are few barriers to entry and exit.

 Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost the same as in perfect competition, with the

exception of monopolistic competition having heterogeneous products, and that monopolistic competition involves a great

deal of non-price competition (based on subtle product differentiation). A firm making profits in the short run will break even in

the long run because demand will decrease and average total cost will increase. This means in the long run, a

monopolistically competitive firm will make zero economic profit. This gives the amount of influence over the market; because

of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm's demand curve is

downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.
Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm's

marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The

difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal;

however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its

goods above average cost and can no longer claim an economic profit
Major characteristics

There are six characteristics of monopolistic competition (MC):

 product differentiation

 many firms

 free entry and exit in long run

 Independent decision making

 Market Power

 Buyers and Sellers have perfect information

Product differentiation

MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as

to eliminate goods as substitutes. Technically the cross price elasticity of demand between goods would be

positive.In fact the XED would be high.[6] MC goods are best described as close but imperfect substitutes.[6] The

goods perform the same basic functions. The differences are in "qualities" and circumstances such as type, style,

quality, reputation, appearance, and location that tend to distinguish goods. For example, the function of motor

vehilces is basically the same - to get from point A to B in reasonable comfort and safety. Yet there are many

different types of motor vehicles, motor scooters, motor cycles, trucks, cars and SUVs.

Many firms

There are many firms in each MC product group and many firms on the side lines prepared to enter the market. A

product group is a "collection of similar products".[7] The fact that there are "many firms" gives each MC firm the

freedom to set prices without engaging in strategic decision making.The requirements assures that each firm's

actions have a negligible impact on the market. For example. a firm could cut prices and increase sales without fear

that its actions will prompt retaliatory responses from competitors.

How many firms will an MC market structure support at market equilibrium? The answer depends on factors such as

fixed costs, economies of scale and the degree of product differentiation. For example, the higher the fixed costs the

fewer firms the market will support.[8] Also the greater the degree of product differentiation - the more the firm can

separate itself from the pack - the fewer firms there will be in market equilibrium.
Free entry and exit

In the long run there is free entry and exit. There are numerous firms awaiting to enter the market each with its own

"unique" product or in pursuit of positive profits and any firm unable to cover its costs can leave the market without

incurring liquidation costs. This assumption implies that there are low start up costs, no sunk costs and no exit costs.

Independent decision making

Each MC firm independently sets the terms of exchange for its product.[9] The firm gives no consideration to what

effect its decision may have on competitors.[10] The theory is that any action will have such a negligible effect on the

overall market demand that an MC firm can act without fear of prompting heightened competition. In other words

each firm feels free to set prices as if it were a monopoly rather than an oligopoly.

Market power

MC firms have some degree of market power. Market power means that the firm has control over the terms and

conditions of exchange. An MC firm can raise it prices without losing all its customers. The firm can also lower prices

without triggering a potentially ruinous price war with competitors. The source of an MC firm's market power is not

barriers to entry since there are none. An MC firm derives it's market power from the fact that it has relatively few

competitors, competitors do not engage in strategic decision making and the firms sells differentiated product.
[11]
Market power also means that an MC firm faces a downward sloping demand curve. The demand curve is highly

elastic although not "flat".

Perfect information

Buyers know exactly what goods are being offered, where the goods are being sold, all differentiating characteristics

of the goods, the good's price, whether a firm is making a profit and if so how much.[12]

Market Structure comparison

Profit
Number Market Elasticity of Product Pricing
Excess profits Efficiency maximization
of firms power demand differentiation power
condition

Perfect Perfectly Price

Infinite None None No Yes[13] P=MR=MC[14]
Competition elastic taker[14]

Highly
Monopolistic Yes/No Price
Many Low elastic (long High[16] No[18] MR=MC[14]
competition (Short/Long)[17] setter[14]
run)[15]

Relatively Absolute (across Price

Monopoly One High Yes No MR=MC[14]
inelastic industries) setter[14]
EXAMPLES

CASE 1

Is It "Always Coca-Cola?" Coca-Cola Tries To Ensure It Is.

Subject Advertising Topic Monopolistic competition Key Words Prices, profit, volume, consumers, money, unique features, ads News

Story

Coke is in the midst of raising its prices. Like Pepsi, it is hoping that profit will increase even if volume decreases. Much depends on

whether consumers switch from coca-cola to other soft drinks such as teas, fruit drinks, sports beverages, and water.

It is therefore willing to spend more money on advertising to retain customers. It is replacing its slogan of "Always Coca-Cola" with

"Coca-Cola – Enjoy." The campaign highlights the unique features of Coke, such as the flavor, the spice, the aroma, and the bottle.

The intent is to stress the usefulness of coke in refreshing consumers and in creating fun and good times. Consequently, the ads

feature bubbles and fizzing energy. Some also recall good times in days gone by. The jingle is catchy, and is played in at least 19

musical genres from urban/Latino/rap to country/traditional.

(Updated March 1, 2000)

CASE 2

Hey, Hon! Get me a Happy Meal While You Get One For the Kids! Subject McDonald's Has a New Product Topic Supply and

Demand; Monopolistic Competition, Product Markets, Utility and Consumer Choice Key Words

New Product, Differentiation; Fast Food Industry

News Story

In response to changing consumer trends toward healthier eating, McDonald's announced that on May 6, 2004, it would roll out Adult

Happy Meals, called "Go Active!" meals, in all 13,600 U.S. domestic McDonald's restaurants. Selling for approximately $4.99 each,

the meals include a salad, bottled water, and a pedometer. In addition, McDonald's is phasing out its Super-Size quantities as well as

introducing all-white-meat chicken in its McNuggets. Soon McDonald's plans to add fresh fruit and juice options in its Happy Meals for

children.

While McDonald's is not altering its principle hamburger-and-fries menu, it is responding to society's greater concern over health, and

in addition to adding the healthier options, McDonald's restaurants are offering pamphlets advising consumers how to alter the fat,

caloric, and/ or carbohydrate intake as customers order off of its menu. This is also part of a larger trend in the fast-food industry.

Other chains, such as Hardee's, has introduced a low-carb version of its "Thickburger."

(Updated June, 2004)

Monopolistic Competition

Let us continue with our example of the pushcarts, but let us change assumptions. Let the beach be very, very long, and let buyers

face a cost in get to and from the seller. To make this second assumption specific, assume that it costs buyers $1.00 to travel a mile.
Finally, assume that there is one seller on the beach and that everyone values the product he sells at $10.00.

If the seller prices his product at $6.00, how many people will buy it? He should get all those people who are located less than two

miles from him. To see this answer, consider someone located one mile away. This person finds that the product costs $8.00 to get

because she must pay $6.00 and travel two miles (one going and one returning). Because $8.00 is less than the benefits of $10.00

she gets from the product, she will buy. If she was located three miles away, the product would now cost her $12.00 ($6.00 to the

seller and $6.00 of transport costs), so she would not buy.

Now, suppose that another seller decides to locate on our very long beach. Unlike the Hotelling beach, he will not locate next to the

original seller. The assumptions of transport costs and long beach change this result. In fact, the new seller should move down the

beach until he has his own four-mile stretch of beach.

Suppose that both sellers are doing a great business and getting rich. Because it is very easy to roll another push cart onto the beach,

the unusually high returns in this business should attract new sellers. Suppose that a new seller locates exactly two miles away from

our first seller. How much of the beach will each control? If they both charge the same price, then they will evenly split the beach

between them, or each will attract customers within one mile.

However, to make the story a bit more complicated, suppose that the new seller raises his price to $7.00. If the original seller still

charges $6.00, then the dividing line separating customers between them will be 1.25 miles from the original seller and .75 miles from

the higher-priced seller. (If you check the cost of the buyer at this point, you should see that it costs her $8.50 to go to either seller.)

In the previous example each seller has some control over price. Each realizes that if he charges a higher price, he loses some

customers, but not all of them. In this way, the sellers are like monopolies: They are price searchers facing downward-sloping demand

curves. However, they also are in an industry that has easy entry and exit, and as a result, there will be no long-term profits (as

economists define profits). This situation resembles that of the price takers in perfect competition, the sellers we discussed when we

drew supply curves. Because it has both elements of monopoly and competition, economists classify an industry of this type as

monopolistic competition.

The model of monopolistic competition puts our situation into a more familiar form of demand and cost curves. The illustration below

shows a seller with a downward-sloping demand curve and a conventional marginal cost curve. Because the demand curve slopes

downward, the marginal revenue curve lies below it. The seller maximizes profit by selecting that output at which marginal revenue

equals marginal costs and charges as much as he can, which is price P2. In the long run, there can be no economic profit because

there is free entry into the industry. If there are any profits, others will enter the industry, positioning themselves to take away

customers from the most profitable sellers. The zero profit condition implies that at equilibrium, average revenue (which is demand)

must just equal average cost. When average revenue equals average cost, average profit is zero, and so total profit must also be

zero.