Download Monopolistic competition

CLAUDE COQUILLEAU/FOTOLIA
Monopolistic
competition
Many golf clubs have spare capacity at off-peak
times during the week but are busy at weekends
Robert Nutter discusses the role of monopolistic competition in
the economy
M
onopolistic competition is a market
structure that, because it is inefficient, is an example of an imperfect market.
It is sometimes confused with oligopoly but
in many ways it is more similar to perfect
competition. The word ‘monopolistic’ gives
the impression of a big firm with market
power and yet firms in a monopolistically
competitive market have relatively little
market power. What is the theoretical basis
of this market structure? What relevance
does it have in a modern economy and are
there any implications for public policy?
An imperfect market
Edward Chamberlin wrote arguably the
definitive book on this market, The theory
of monopolistic competition, in 1933 and
further work on the subject was written by
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the famous economist, Joan Robinson. In
monopolistic competition there are many
producers and consumers, with the market
composed of a large number of small firms.
These firms produce a differentiated product
or service, with the opportunity for them
to build brand loyalty among their customers. Non-price competition is commonplace
and the product differentiation is supported
by advertising. However, the products are
not dissimilar and they can be seen as close
but imperfect substitutes with positive cross
price elasticity relationships.
Firms do have some control over price
with a downward sloping demand curve,
so an increase in price will not lead to all
customers being lost (as in perfect competition). Therefore firms are price makers
not price takers. As the products of each
firm are differentiated, they have certain
unique characteristics that give the firm a
degree of monopoly power, which explains
the ‘monopolistic’ in monopolistic competition. However, each firm has so little
market power that a rise or fall in price will
have an insignificant impact on the overall
market. A firm could cut prices to increase
sales without having to worry about retaliation from competitors (as may happen in an
oligopoly). Firms are assumed to be profit
maximisers and set prices so that marginal
cost (MC) equals marginal revenue (MR).
Contestability
Is a monopolistically competitive market
perfectly contestable? Firms making losses
can apparently leave the market without
facing exit barriers such as sunk costs.
Equally, firms wishing to enter the market
will not face any entry barriers and may be
attracted by the lure of abnormal profits.
However, in practice it could be argued that
Economic Review
Efficiency
advertising to support product differentiation and brand loyalty is a sunk cost and
an exit barrier. Potential new entrants will
have to face the entry barrier of the brand
loyalty of customers to already established
firms. However, there is little doubt that the
market is contestable to some extent.
In a monopolistically competitive market,
firms can only make abnormal profits in the
short run, possibly when there are low levels
of competition. Figure 1 shows short run
abnormal profit being made, this being the
shaded area where average revenue exceeds
average costs (AR > AC).
$
MC
PS
AC
ACS
AR
MR
QS
Output
Figure 1 Firms may make abnormal profits
in the short run
It is equally possible for firms in this
market to be making losses in the short run,
where average revenue is less than average
costs (AR < AC), as shown in Figure 2. A firm
making losses could survive for a short
while by just covering its variable costs
(price > AVC) but it would have to exit the
industry in the long run.
$
Loss
MC
AC
AVC
AC*
p*
AVC*
MR
Q*
AR = DD
Output
Figure 2 A firm making losses in the short run
In such a contestable market, firms can
easily enter or leave the market. When
incumbent firms are making abnormal
profits, new entrants will come into the
market to take advantage of it. Incumbent
firms will find that their share of the market
will fall as they have to share it with more
firms and, as a result, their demand curves
will shift to the left. The entry of new firms
will continue until firms can only make
normal profits (AR = AC). When normal
November 2011
BERTYS30/FOTOLIA
Profits
Hairdressers are an example of monopolistic
competition in the economy
profits are earned, firms in the market have
no incentive to enter, or leave, the industry.
Normal profits indicate that the opportunity
costs of a firm’s resources are zero and the
same profit can be earned by the firm in its
next most profitable activity.
If firms were making losses in the short
run then many would leave the industry,
as their resources could be more profitably employed in another activity. The exit
of some firms means that those remaining
enjoy a rise in demand with their demand
curves shifting to the right. The exit of firms
continues until those firms remaining are
making normal profits.
There are numerous welfare and efficiency
issues surrounding monopolistic competition. In Figures 1–3 the price is above
marginal cost, which means that the market
is allocatively inefficient. When price is
greater than marginal cost, the value that
consumers place on the last unit bought
is greater than the cost of producing that
unit, so the product is under-produced. The
shaded area in Figure 4 shows the welfare
loss under monopolistic competition. In the
range of output between the profit maximising output (Pm) and the allocatively efficient level (Pe), price exceeds marginal cost.
In addition, the firms in monopolistic competition produce at a level of output below
minimum average cost, making them productively inefficient. This indicates that
firms operate at a level of output below
optimum capacity. In Figure 3, the profit
maximising level of output is below the level
of output associated with minimum average
costs. Allocative and productive inefficiency
make monopolistic competition an imperfect market.
$
Deadweight loss
MC
Pm
PC
Long-run equilibrium
D
Whether firms are making abnormal profits
or losses in the short run, the long-run equilibrium position is shown in Figure 3. In
the long run the average cost curve is at a
tangent to the average revenue (demand)
curve and so normal profits are made
because average revenue equals average costs
(AR = AC). Normal profit does not imply
something akin to breakeven. Normal profit
means that the firms could only make the
same level of profit if their resources were
transferred to another activity.
$
LRMC
LRAC
PL
AR L = D L
MR L
QL
Figure 3 Long-run equilibrium under
monopolistic competition
Output
MR
Qm
QC
Q
Figure 4 The welfare cost of monopolistic
competition
In the long run, the number of firms
in monopolistic competition is inefficient
— there are too many — and each time
a new firm enters the industry it creates
externalities. As consumers get a wider
choice of products, all differentiated, this
creates a positive product variety externality.
However, there is a negative business stealing externality because new firms entering a
market steal customers from existing firms.
In monopolistic competition there is
likely to be advertising and this can have
negative effects, such as manipulating consumer tastes, promoting irrational brand
loyalty, and raising the costs and thus prices
of firms. However, advertising provides valuable information, establishes brand names
that consumers can rely on and fosters
healthy competition between firms.
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Relevance in a modern economy
Does the theory of monopolistic competition have any relevance in a modern
economy? There is no doubt that monopolistic competition exists. Examples, mainly
in the services sector, include hairdressers,
family-owned restaurants, dry cleaners,
laundries, car servicing and possibly golf
clubs. Many of these services are often part
of chains, or in the form of franchises, and
with some golf clubs there is public sector
ownership by local authorities. However,
these firms produce differentiated products
and normal profits are features of these
sectors. There is also significant spare
capacity, particularly at off-peak times, for
example half-empty restaurants and hairdressers on a Monday. Equally, many golf
clubs are busy at weekends but not during
the week. With extra/marginal customers
adding significant amounts to profit, this
explains why restaurants send Christmas
cards to their regular customers inviting
them to go more, often with special offers.
It is likely that the term normal profit is an
accurate feature of this type of firm. For
instance, many family-owned restaurants
will make high-enough profits to survive
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comfortably but not to make excessive
profit. It is likely that the resources they
employ could not make higher profits in
another activity.
Public policy issues
With so many ‘inefficient’ firms, should
there be more regulation of monopolistic
competition? Hence, are there public policy
issues? Monopolistic competition does not
have the desirable qualities of perfect competition, where the total community surplus
(consumer surplus plus producer surplus)
is maximised. However, it is very difficult
for there to be practical policies to correct
the market failure. Price cannot be reduced
(closer to marginal cost) because the firms
are only making normal profit as it is.
The very low barriers to entry allow entry
and exit to occur until long equilibrium is
reached, where only normal profit is made.
This is not a market where there are
excessively high prices, long run abnormal
profits, or anti-competitive practices. The
inefficiencies in monopolistic competition
are harder to measure and not as easy to
correct as in, for example, oligopoly.
Therefore, there is no easy way for public
Review notes
1 Monopolistically competitive markets
have a large number of small firms selling
differentiated products.
2 Monopolistic competition is a market that
is allocatively and productively inefficient.
3 Firms in this type of market cannot earn
abnormal profits in the long run, as there is
a high level of contestability.
4 There are numerous examples of
monopolistic competition in the economy,
such as hairdressers, family-owned
restaurants and dry cleaners.
5 Despite the inefficiency in the market,
there is little scope for public policy to
improve the outcome.
policy to improve the outcome in the
market. Nonetheless, something akin to
monopolistic competition is an integral part
of the small-firms sector in the UK and is
likely to remain so in an economy where
people increasingly demand personal services. We should also recognise the value
that people gain from having variety of
choice. £
Robert Nutter is head of social science at
Watford Grammar School for Girls.
Economic Review