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Gareth Jones - http://cyro.cs-territories.com/ Economics: Unit 4: Monopolistic competition M onopolistic competition has many characteristics from perfect competition and the characteristic ofproduct differentiation from a M onopoly. W hilst first are price makers they are no absolute price makers as there are many smallfirms and no firm has a significant market share. The demand curve for monopolistic competitors is elastic as there are many firms, w hereas the monopolists is much more inelastic due to the lack ofclose substitutes. The follow ing diagram can be used to show the cost structure ofa monopolistic competitor in the short run,w here the shaded area represents supernormalprofits. Price and costs MC A TC Pm = Supernormalprofits AC MC OF LAST UNIT MR O D = AR = P Qm Q In the long run the demand curve for the individualfirm w illshift to the left,as more firms w illbe producing more differentiated products. This assumes that the market demand remains constant and that demand for the product remains the same as the new firms enter the market. Price and costs MC A TC Pm = Reduction in consumer surplus Po MR O Qm D = AR = P Qo Q Gareth Jones - http://cyro.cs-territories.com/ This shifting ofthe demand curve stops at a point w here the demand curve is tangentialto the A TC curve. There is then a single price and quantity at w hich the firm can produce to break even. N o supernormalprofits are made as A R = A TC. A t any other output A TC >A R,so the firm w illmake losses. Efficiency in Monopolistic competition Qo,the optimum output for society is greater than Qm,so the market is not productively efficient. Qo – Qe is the excess or unused capacity ofthe firm. This is due to idle capitalas the firm has had a reduce production as more firms enter the market. Pm > M C,so the market is not allocatively efficient. To utilise this capacity market demand must increase or firms must leave the market. This w illincrease demand for the product from the individualfirm and so utilise some ofthe firm’s excess capacity. In monopolistic competition consumer surplus is reduced by the shaded region in the above diagram. The consumer is over charges and the firm produces an output below the optimum. Competition in Monopolistic competition In monopolistic competition there is lots ofnon-price competition. The firm can compete on its product through differentiation,the place it sells the product through effective and appropriate distribution and promotion to improve product know ledge such as specialoffers,advertising and after sale service. Past paper Q uestion June 2002,Q3. The existence ofmany smallhigh street travelagents,each w orking w ellbelow capacity,is a sign ofinefficiency. (a) U sing diagrams,explain the short ad long run equilibrium positions ofa firm in monopolistic competition. M onopolistic competition is a market structure in w hich firms are price makers, there are a large number ofsmallfirms producing differentiated products and there are no barriers to entry in the long run. First producing under this structure are making supernormalprofits in the short run. The firm has a dow nw ard sloping demand curve and are aiming to maximise profits so product at M C = M R,as show n below . The shaded area represents the supernormalprofits made in the short run. Gareth Jones - http://cyro.cs-territories.com/ Price and costs MC A TC Pm = Supernormalprofits AC MC OF LAST UNIT MR O D = AR = P Qm Q In the long run supernormalprofits attract new entrants into the market so reduce the demand for each firm,assuming aggregate demand in the market remains unchanged. This erodes profits and leaves under utilised capacity or Qo-Qm,as show n below . Price and costs MC A TC Pm Po MR O Qm D = AR = P Qo Q (b) D iscuss the view that greater efficiency w ould result ifthe travelagent industry show ed more characteristics ofa monopoly. The market structure in w hich the travelagent is operating has many characteristics ofmonopolistic competition. There are differentiated products as different firms offer different types ofholiday,there are low barriers to entry as an individualcan set up a company and operate it from home. The Internet has also improved information so near perfect information exists in the market as prices and holidays are easily comparable on the Internet. There are a large number of smallfirms operating in the market and the market has some other characteristics such as brand loyalty typicalofmonopolistic competition. The market for travelagents therefore has most ofthe characteristics ofa monopolistically competitive market. This means that there are too many firms in the market,as competition requires allfirms to produce w ith excess capacity. Gareth Jones - http://cyro.cs-territories.com/ Ifthe market structure w ere a monopoly the firm w ould be an absolute price maker so could exploit the consumer by over charging them and producing an output low er than the socialoptimum. Through price discrimination policies the monopolist can reduce consumer surplus. A s there is no competition the firm can supply an inferior quality product and operate inefficiently due to the barriers to entry in the market that prevent new entrants. The firm w illcharge a price higher than the M C so the firm is not allocatively efficient and the lack ofcompetition does not force the firm to produce at the low est point on it’s A TC curve. H ow ever in the long run under monopolistic competition no supernormalprofits are made,w hereas under a monopoly supernormalprofits are sustained in the long run due to the barriers to entry. These supernormalprofits can be used for research and development,w hich in the case ofthe travelagent could be research into new holiday destinations. A pure monopolist can also reduce priced by exploiting economies ofscale, especially marketing economies ofscale by renting entire hotels through the holiday season. This reduces the firm’s costs so low ers the marginaland average totalcost curves. The monopolist can pass on this reduction in costs to the consumer in the form oflow er prices. A pure monopolist may also operate more efficiently in the long run than a monopolistic competitor as a monopolistic competitor w illhave excess capacity as there are too many firms in the market w hereas a pure monopolist w illnot have excess capacity. In conclusion neither market structure w illresult in greater efficiency,as both market structures are inefficient in the long run. H ow ever,a monopolistic competitor faces competition and this forces them to become more efficient than a pure monopolist w ho faces no pressure to become efficient,pass savings onto consumers or invest supernormalprofits in research and development. The market structure ofthe travelagent market is more accurately represented by the oligopoly market structure as a few large firms dominate the market w ith a large number ofsmalltravelagents specialising in particular holidays. These notes are from lessons on 29/09/2004 and 06/10/2004.