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Transcript
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 2 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. 3 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 4 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