Download Spotnomics March 2014(1).pub

MARCH 2014
MONTHLY NEWSLETTER
Department of Economics
SpotNomics
Characteristics of Monopolistic Competition
Content Editor: Dr. E. Azzopardi
Contributor: Mr. Christopher Fava
This Issue
Great Economic Thinkers
Monopolistic Competition
Examination Success
Monopolistic Competition—Q & A
Great
Economic
Thinkers
Edward Hastings Chamberlin
Edward Hastings Chamberlin (May
18, 1899 – July 16, 1967) was an
American economist, known for his
theory on imperfect competition. His
book Theory of Monopolistic Competition (1933), along with Joan Robinson’s The Economics of Imperfect
Competition (1933), started what is
known as the monopolistic competition
revolution. Chamberlin's book provided insights into competitive markets
noting the importance of factors as
product differentiation, the advantages
of location, advertising and brand preference.
Chamberlin argued that even though
the situation on the market may look
like that of pure competition, where a
large number of buyers and sellers participate in economic games, in reality it
is far from that. "Any thing which
makes buyers prefer one seller to another, be it personality, reputation, convenient location, or the tone of his
shop," will distort the situation of pure
competition (p.8). In addition: "where
there is any degree of differentiation
whatever, each seller has an absolute
monopoly of his own product, but is
subject to the competition of more or
less imperfect substitutes. Since each is
a monopolist and yet has competitors,
we may speak of them as ‘competing
monopolists (p.9).’
Source:newworldencyclopedia
The market structure monopolistic competition has features of both perfect competition and monopoly. A monopolistically competitive market consists of a large
number of producers each supplying a slightly differentiated product. The output of
one firm is a close (but not perfect) substitute for the outputs of other firms. Such
product differentiation is often achieved or reinforced by brand names and advertising. Examples include retail clothing stores, restaurants, barber shops and so on.
In addition, monopolistic competition is said to exist when there are no barriers to
enter into or exit from the industry (so that firms cannot make abnormal profits in
the long run).
Differentiation grants each firm some monopoly power, that is, each firm has some
control over the price of its product. On the other hand, the presence of close substitutes provides competition. In other words, the term “monopolistic” refers to the
small monopoly power that firms have by virtue of their differentiated product. The
term “competition” implies that there is a large number of firms and there is freedom of entry and exit so that firms cannot make above-normal profits in the long
run Because each firm in monopolistic competition has a monopoly over its own
brand of the product, each firm faces a downward-sloping demand curve for its
product. Therefore, average and marginal revenue diverge, just as they do under
pure monopoly.
Many fish sellers at Marsaxlokk selling an almost undistinguishable product
Examination Success
Do not confuse a monopolistically competitive market and a monopolistic market.
Under long-run equilibrium the demand curve just barely touches the long run average total cost curve. The two curves are tangent to each other. It is important to
draw these two curves touching each other without intersecting/crossing (See Figure 1b).
The quantity that minimises average total cost is referred to as the minimum efficient scale (MES). A monopolistically competitive firm produces an output level
below the MES and is said to operate with excess capacity (See Box 2).
The product differentiation inherent in monopolistic competition leads to the use of
advertising which can result into both beneficial and detrimental effects (See Box
3).
Monopolistic Competition—Q & A
AR
MR
AC
MC
A.R.
M.R.
A.C.
M.C.
LRMC
MC
ATC
P
A
LRATC
P2
C
Minimum LRATC
B
MR = MC
MR = MC
D2(AR2)
D1(AR1)
MR2
MR1
0
Q1
0
Output
FIGURE 1(a):Short-run equilibrium
Q2
Q3
Output
FIGURE 1(b): Long-run equilibrium
How does long-run equilibrium under monopolistic competition compare with other market structures? The monopolistically competitive firm in the long-run produces where MC equals MR—as in the short run—but now only earns normal profit
because average cost equals average revenue. The fact the firm earns only normal profits in the long run is the only similarity
between monopolistic competition and perfect competition. Although the firm earns only normal profit in the long run, the average cost of production is not pushed to its minimum point as it is under perfect competition. This implies that each individual
firm operates with excess capacity (see box below). In monopolistic competition there is no optimal allocation of resources
because the price consumers pay for the last unit they consume does not equal the marginal cost of production. Such mark-up
of price over marginal cost results into a deadweight loss as in monopoly. If at P2, monopolistically competitive firms are already making zero economic profits, requiring them to lower their prices to equal marginal cost would cause them to make
losses.
What is meant by excess capacity under monopolistic competition? Excess capacity is the difference between the ideal output and the profit-maximizing output. The monopolistically competitive firm produces that output level where the demand
curve is tangential to the LRAC curve. Since the demand curve is downward sloping, the LRAC curve also has to be downward
sloping at this point. Hence it produces an output level at which ATC is still falling—production costs are higher than necessary. If the firm maximizes out of its capacity, it has to reduce the price so much that it ends up making a loss.
The higher production cost resulting from excess capacity may be viewed as a social loss. However, Chamberlain argues that
people may be willing to pay for this differentiation in the form of excess capacity. Thus, the deal output is not necessarily the
one given by the minimum point of the LRAC curve. Of course, excessive proliferation of products of different quality is a
waste of society’s resources but the cost of boredom produced by having uniform products has to be taken into account as well.
What is the effect of advertising? Chamberlin coined the term "product differentiation" to describe how a supplier may be
able to charge a greater amount for a product than perfect competition would allow. Product differentiation means the process
by which sellers try to distinguish their products from others through advertising.
There is persuasive advertising and informative advertising. Advertising increases costs, but it also shifts the demand curve
rightwards. There could be both a rise or a fall in price. Nevertheless the role of advertising is to provide information to uncertain consumers about product quality. Advertising does increase the price but consumers necessarily receive something when
they pay a higher price for an advertised brand.
John Kenneth Galbraith in the The Affluent Society published in 1958 was skeptical of the market system for satisfying desires
that it has itself created. He argued that as advertising enhanced the desire for private goods, public spending on such items as
better schools and better parks suffered. According to Galbraith, the end result was ‘private opulence and public squalor.’
However, Frederic Hayek contended in his book The Road to Serfdom published in 1944 that “it is because each individual producer thinks that the consumers can be persuaded to like his products that he endeavours to influence them. But though this
effort is part of the influences which shape consumers’ taste, no producer can in any real sense ‘determine’ them.’
Source: Mankiw, G. (2007) Principles of Economics, Thomson, p.383