Download Monopolistic competition

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Monopolistic competition
By the end of this chapter, you should
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explain the assumptions of
define and give examples of
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explain and illustrate the demand
competition
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explain how firms maximize proftts
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explain and illustrate short run
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monopolistic competition
explain and illustrate the
competrtron
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explain the movement from short
competition
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explain and illustrate
and long run in monopolistic
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competition.
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The theory of monopolistic competition was developed by xdward
Chamberlin (1899-1967), an Americal economist. He was dissatislied
with the two extreme theodes that existed at the time, perfect
competition and monopoly, so wanted to devise someth.ing more
realistic that would sit between the two existing theories. In simple
terms, a monopolistically competitive market is one with many
competing firms where each firm has a little bit of market power. This
is why we have the term "monopolistic", as firms have some ability to
set their o\ry'n prices.
The assumptions of monoPolistic comPetition
The assumptions for monopolistic competition are as follows.
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The industry is made up of a fairly large number oI firms.
The firms are small, relative to the size of the industry. This means
that the actions of one firm are unlikely to have a great effect on
any of its competitors. The lirms assume that they are able to act
independendy of each other.
The firms all produce slightly differentiated products. This means
that it is possible for a consumer to tell one firm's product from
another.
Firms are completely free to enter or leave the industry. That is,
there are no barriers to entry or exit.
The only difference lrom perfect competition is that in monopolistic
competition there is product differentiation. Product dilferentiation
exists when a good or service is perceived to be dil{erent from other
goods or services in some way. Products may be dilferentiated by
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brand name, colour, appearance, packaging, design, quality of service,
skill levels, and many other methods. Examples of monopolistically
competitive industdes are nail (manicure) salons, car mechanics,
plumbers, and jewellers.
Although it may appear to be a small difference from the assumptions
of perfect competition, this leads to a markedly different market
structure. As the products are differentiated there will be some extent
of brand loyalty. This means that some of the consumers will be loyal
to the product and continue to buy it if the price goes up a little. For
example, it may be that the customers of a certain plumber will stay
with that plumber when she raises her prices above local rivals,
because they believe that she is slightly more skilled than her
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competitors.
This brand loyalty means that producers have some element of
independence when they are deciding on price. They are, to an
extent, price-makers, and so they face a downward sloping demand
curve. However, demand will be relatively elastic since there are
many, only slightly different, substitutes.
Student workpoint 9.1
Be a
thinker-considel
and explain
Try to think of an example of a
market in your area that is in
monopolistic competition. \A,4th
reference to the assumptions of
the model, explain your choice.
Have you ever walked down a street in a tourist area and seen a lot of restaurants
with similar menus? Explain why they might be considered to be in monopolistic
competition.
The demand curve facing a monopolistically competitive firm is
shown in Figure 9.1.
The firm faces a downward sloping demand curve with a marginal
revenue curve that is below it and produces so that it is maximizing
profits where MC : MR. This means that the firrn in Figure 9.I will
produce an output of q and sell that output at rhe pdce of P
Possible short-run profit and loss situations in
monopolistic competition
Just as in perlect competition,
it
in monopolistic
competition to make abnormal profits in the short run. This is shown
in Fig]jJe 9.2.
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lVtR
Output
F Bure 9.1 lhe demand curve for a firm
in monopolistic competition
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Output
is possible for firms
Figure 9.2 Short-run abnormal profits in
monopolistic competition
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In this case, the firm is maximizing profits by producing at the level
of output where MC = MR, and the cost per unit (AC) of C is less
than the selling price of P. There is an abnormal profi.t that is shown
by the shaded area.
It is also possible that a firm in monopolistic competition may be
making losses in the short run and this is shown in Figure 9.3. Once
again, the firm is producing where MC : MR, but this time the cost
per unit, C, is above the price, P, and the amount of losses is shown
by the shaded area.
The long-run equilibrium of the fitm in monopolistic
competition
whether fims are making abnormal profits or losses in the short run,
because of the freedom of entry and exit in the industry there will be
a long-run equilibrium, where all of the firms in the industry are
{
l,4onopolistic
competition
[!!
(.)
F
=
6
Output
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Figure 9.3 Short-run losses in
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monopolistic competition
making normal profits.
II the fims are making short-run abnormal profits, then other
firms will be attracted to the industry. Since there are no barriers
to entry it is possible for these other firms to join the industry. As
they enter, they will take business away from the exisdng firms,
whose demand curves will start to shift to rhe left. If firms are making
short-run losses, then some of the firms in the industry will start to
leave. The firms that remain will Iind that their demand curves start
to shift to the right as they pick up trade from the leaving firms.
This analysis explains why it is not uncommon to see similar shops or
services spring up in an area. Imagine that a new sushi restaurant
opens up in a district. Soon it is so popular that there is a line outside
the door every evening. Other catering entrepreneurs will be
attracted to the possibility of doing so we11, and so it is likely that
another sushi restaurant will open up in the area. It may not happen
immediately, but eventually this is likely to result in a fall in demand
for the original sushi restaurant as some of its customers will switch.
If demand continues to be strong, then even more restaurants will
open. Each restaurant will try to distinguish itself from the othersperhaps by staying open longer, oflering a "Happy Hour", special
theme nights, or free children's meals to name just a few possibilities.
This product differentiation is also known as non-price competition.
Whatever the short-run situation, in the long run the firms will end
up in the position shown in Figure 9.4, with all making normal profits.
T?re firms are maximizing profits by producing at the level of output
where MC : MR and, at that output, the cost per unit, C, is equal to
the pdce per unit, P Each firm is exactly covering its costs, including its
opportunity costs, and so there is no incentive for firms to leave the
industry. Fims outside the industry will not enter, since they will be
aware that their entrance would lead to losses for everyone.
Table
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9.I summarizes the characteristics of monopolistic competition
and illustrates how Italian restaurants in a city might be considered to
be close to a monopolistic competltion market structure.
Figure 9.4 Long-run equilibrium in
monopolistic competition
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Mlonopolistlc competition
Very large number of firms
Each firm very small relative to the
size of the market
Coods are differentiated
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(Different menug emphasis on pash, emphasis on pizzas)
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No barrlers to entry or exit
Very low baniers (low capital costs, no special
expertise, not likely to be large economies of scale,
some brand loyalty)
Perfect information
Fairly open, but not perfect
Abnormal profits possible in short
run, but not in lonS run
as the existinS ones are earning abnormal profits.
l\,4ore and
more ltalian restaurants will be set up as long
Tab e 9.1 ltalian restaurants as an example of a monopolisitic competition market
struciure
Student workpoint 9.2
Be a
I
2
5
thinker-explain and illustrate the following:
Why can a firm in monopolistic competition not earn abnormal
profits in the long run?
Draw a diagram of a firm in monopolistic competition that is in long-run
equilibrium. (This is likely to be the most difficult diagram you've done
so far, as it is challenSing to draw the relationships accurately!)
Look around your area, and try to tind an example of monopolistic
competition. Draw up a table such as 9.1 to apply the characteristics of
monopolistic competition to your example.
Productive and allocative efficiency in monopolistic
competition
We know that productive efliciency is achieved at the level of output
where a firm produces at the lowest possible cost per unit, the point
where AC is at a minimum. This is the point where the MC curve
OutPut
Figure 9.5 Produdive and allocative
efficiency in the short run in
monopolistic competition
cuts the AC curve.
Allocative efficiency is achieved at the level of output where the MC
curve cuts the AR curue: the socially optimum level of output.
Figure 9.5 shows the two possible short-run positions in monopolistic
competition and abnormal profits and losses. We see that the firm
produces at the level of output where profits are maximized, q, as
opposed to the productively efficient level of output, qr, or the
allocatively efficient level of output, qr.
In the long run, the situation is the same. This is shown in Figure 9.6.
The firm is again producing at the profit-maximizing level of output,
q, and not at the productively efficient level of output, q1, or the
allocatively eflicient level of output qr.
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OutPut
Figure 9.6 Productive and allocative
efficiency in the long run in monopolistic
competition
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fi,4onopoListic
comp"tition
!!!!
Monopolistic competition in comparison with
perfect competition
Unlike pedect competition, where in the long run the firms are profitmaximizers, productively efficient, and allocatively efficient, firms in
the long run in monopollstic competition, although maximizing
profits, are neither productively nor allocatively efficient.
However, even though the firm in monopolistic competition is not
allocatively elficient, because it does not produce where MC : AR,
and is not productively efficient, because it does not produce where
MC - AC, the inefficiency is not drue to the firm's ability to restdct
output and increase pdce as in a monopoly. The inefficiency is, in
fact, the result of the consumers' desires for variety. Though
allocative efficiency does not occur, it is hard to argue that consumers
are worse off with monopolistic competition than with perfect
competition, since the difference is due entirely to consumer desire to
have differentiated products.
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Rather than having a per{ectly competitive situation, where
consumers pay lower pdces but are only able to purchase a
homogeneous product, monopolistic compe tition gives consllmers
the opportunity Io make choices. This is why they are prepared to
pay slightly higher prices for the products.
EXAMINATION QUESTIONS
Paper l, part (a) questions
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2
5
With the help of a diagram, explain the level of output that a profit-maximizing
firm will produce at in the long run in monopolistic competition.
[1o norks]
With the help of a diagram, explain how it is possible for a firm in monopolistic
competition to earn abnormal profits in the short run.
[10 morks]
frm in monopolistic competition earning abnormal
profits is productively and allocatively efficient.
[10 motks]
Explain whether or not a
Paper
I a
essay question
Explain the differences between the assumptions of perfect comPetition and
b
Yor,t
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monopolistic competition.
[10 morks]
Evaluate the view that it would be beneficial if all markets were in
perfect competition.
[15 norks]
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Diagram(s): A firm in monopolisii, ,ompetition oarning abnormal
profits in tho short run and tho a{usimen.t to the \ong-run equilibrium
Hinl: ton6idrr oach of |ho as5umpii0ns of tho monopollslic 4omPetition
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Oligopoly
By the end of this chapter, you should be able to:
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explain the assumptions of oligopoly
distinguish between collusive oligopoly and
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distinguish between formal collusion and tacit
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define a cartel
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explain the role of game theory in oligopoly
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explain and illustrate the kinked demand curve
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explain and give examples of non-price
Ht The assumptions of oligopoly
Oligopoly is where a few firms dominate an industry. The
industry may have quite a few firms or not very many, but the
key thing is that a large proportion of the industry's output is
shared by just a small number of firms. What constitutes a small
number varies, but a common indicator of concentration in an
industry is known as t]le concentration ratio. Concentration
ratios are expressed in the form C\ where X represents the
number of the largest firms. For example, a CRa would show the
percentage of market share (or output) held by the largest four
fims in the industry. The higher the percentage, the more
concentrated is the market power oI the four largest firms.
While other concentration ratios such as a CR5 are measured, it
is the CR4 that is most commonly used to make a link to a given
market structure. While the line between the concentration of
market share or sales in dilferent market structures is subject to
interpretation, Figure 10.1 offers one view.
Percentoge morket shore of lorgest 4 firms (CRa)
Perfecl
competition
l,4onopolinic
competition
Monopoly
oligopoly
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aoncentIatlon
Medium
High
concentration
concentration
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Figure 10.1 CRa ratios in different market structures
For example, in the US malt beverages industry there are 160 Iirms,
and the CR4 is 90%. Thus the lour largest firms produce 907o of the
industry's output and it is an industry with a high concentration of
market power among the largest four companies. In the frozen fish
and seafood industry there are 600 firms and the CR4 is 19, suggesting
low concentration. We may conclude that the malt industry is an
oligopoly and the frozen fish and seafood industry is in monopolistic
competition.
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Student workpoint
l0.l
Be a thinker-classify the
following
oligopoly
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How would you classify each of the following industries in the US?
I Breakfast cereal manufacturing: 48 firms, C& :
2 Textile mills: 3,865 firms, CR. : 13,go7o
3 Breweries:494 firms, CRa = 89.70lo
4 Wineries: 637 firms, CRo: 43.2010
82.90/o
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Student workpoint Io.2
Be an
inquirel
The C& tells us how the market share in the industry is concentrated among
the four largest firm' but it doesn't necessarily reveal the extent of the
competition in the industry A CRa of 8Oo/o would suggest high concentration,
but rf fiat market share were to be divided up with the largest company
having 650/o of the market and the other three having 5o/o each, then this
would be very different from each of the four having 200/o equal share.
An alternative indicator of concentration in an industry is known as the
Herfindahl-Herschmann index,
Research task
What is the Herfindahl-Herschmann index? How might it be a better
indicator of concentration than the C&? What are the levels of the CR4
values that distinguish betveen different categories of comPetition?
Oligopolistic indusries may be very different in nature. Some
produce almost identical products, e.g. petrol, where the product is
almost exactly the same and only the names of the oil companies are
different. Some produce highly differentiated products, e.g. motor
cars. Some produce slightly differentiated products, e.g. shampoo, but
spend huge budgets to persuade people that their product is better.
In most examples of oligopoly, there are disrinct baniers to entry
usually the large-scale production or the strong branding of the
dominant firms, but this is not always the case. In some oligopolies,
there may be low barriers to entry.
However, the key feature that is cornmon in all oligopolies is that there
is lterdependence. Whereas in perfect competition and monopolistic
competition the firms are all too small relative to the size oI the
market to be able to influence the market, in oligopoly there is a small
number of large firms dominating the industry. As there are just a
few firms, each needs to take careful notice of each other's actions.
Interdependence tends to make firms want to collude and so avoid
surprises and unexpected outcomes. II they can collude and act as a
monopoly, then they can maximize industry profits. However, there is
also a tendency for firms to want to compete vigorously with each
other in order to gain a greater market share.
All in all, howevet oligopoly tends to be characterized by price
rigidity. Prices in oligopoly tend to change much less than in more
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oligopoty
competitive markets. Even when there are production-cost changes,
oligopolistic firms often leave thelr prices unchanged.
Collusive and non-collusive oligopoly
Collusive oligopoly exists when the firms in an oligopolistic market
collude to charge the same prices for theh products, in effecr acting as
a monopoly, and so divide up any monopoly profits that may be made.
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There are two types of collusion. Formal collusion takes place when
firms openly agree on the pdce that they will all charge, although
sometimes it may be agreement on market share or on marketing
expenditure instead. Such a collusive oligopoly is often called a cartel.
Since this results in higher prices and less output for consumers, this
is usually deemed to be against the interest of consumers and so
collusion is generally banned by governments and is against the law
in the majority of countries. If a country's anti-trust authority finds
that firms have engaged in anti-competitive behaviour such as pricefixing agreements, then the firms will be penalized with fines or
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other punishments.
Formal collusion between goven.ments may be permitted. The prime
example is OPEC (the Organisation for Petroleum Exporting Countries),
which sets production quotas and prices for the world oil markets.
Tacit collusion exists when firms in an oligopoly charge the same
prices without any formal collusion. This is not as difficult as it
sounds. A firm may charge the same price as another by looking ar
the prices of a dominant firm in the industry, or at the prices of the
main competitors. It is not necessary to communicate to be able to
charge the same prices.
In both formal and tacit collusion, the process is the same. The firms
behave like a monopolist (single producer), charge the monopoly
price, make monopoly profits, and share them according to market
share. This is shown in Figure I0.2.
Collusive oligopoly offers one explanation of pdce dgidity in
oligopoly. If firms are colluding, either formally or tacitly, and rhey
are making their share of long-run monopoly profits, then they may
try lo keep prices stable in order that the situation continues.
Non-collusive oligopoly exists when the firms in an oligopoly do
not collude and so have to be very aware of the reactions of other
firms when making pricing decisions. We say that the behaviour of
firms in an oligopoly is strategic behaviour as they must develop
strategies that take into account all possible actions of rivals. In
order to explain how firms behave in these situations, economists
often use "game theory".
Game theory considers the optimum strategy that a firm could
undertake in the light of different possible decisions by rival firms.
l2a
For simplicity we will look at a situation where there are only two
firms making up a market. This is known as a duopoly. We assume
that the firms have equal costs, identical producls and share the
market evenly, so the initial demand for their goods is the same.
(Rather large assumptions! )
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Output
Figure 10.2 OliSopolists acting as
monopolist
a
ro.
oligopoly
f
The situation is shown in Table l0.i where firms A and B are
contemplating what would be the possible profit outcomes if they
were to change the prices of their identical products.
Firm A's price choices
$s.s0
l-rrm B5
$5.50
price choices
$5.00
$5.00
A & B both high prices
A low price; B high price
A gets $6m
A gets $8m
B gets
B gets
$6m
B low price; A high price
A & B both low prices
B gets $8m
A gets $2m
A gets $4m
B gets
=
o
$2m
3.
$4m
Table I o.l The prediqled profits for firms A and B with different Possible
price combinations
Let us start by assuming that both firms are currently charging a price
of $ 5.50 for their products and so they are both making profits of
$6 million. Now let us assume that they are not colluding, but they
are both separately considering lowering their prices to $5.00.
We can start by considering firm As choices. Firm A has two choices:
it can leave its price unchanged or it can lower it.
If firm A is pessimistic, or cautlous, ir might consider the worst
possible scenarios following its choices, where firm B responds in the
way that is most damaging to firm A. If it does not lower its price and
firm B does, then its profit would fall from $6 million to $2 million. If
it lowers its price and firm B also lowers its price, then its profit would
Iall from $6 million to $4 million. This means that the best option, if
one considers the worst possible outcomes, is to lower prices The
firm is maximizing its minimum profit options and is therefore
known as a "maximin" strategy. The strategy is to adopt the policy
that has the least wont outcome.
If Firm A is optimistic it might consider the best possible scenarios
following its choices, where lirm B responds in the way that is best
for firm A. If it does not lower its pdce and firm B does not lower its
price, then firm A will make $6 million. If firm A lowers its price and
firm B does not lower its price, then firm A will malce $8 million.
Once again the best option is for firm A to lower price. The strategy
of trying to make the rnaximum profit available is known as a
"maximax" strategy. Firm -As "maximin" and "maximax" strategies
are both to lower price.
If we turn the tables and look at the situation from the point of view
of firm B the same logic applies and so the "maximin" and "maximax"
strategies for firm B are also to lower price.
If both firms adopt the strategy of lowering prices, which seems to be
logical, then they will end up making lower profits of $4 million
each. Thus, a price cutting exercise is actually harmful to both fir]lrs'
They would have been better leaving their prices where they were'
They would have benefitted {rom the ability to collude, if they could
have done so.
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, o isopo y
characterized by very large advertising and marketing expenditures
as firms try to develop brand loyalty and make clemand for their
products lcss elastic. Somc nay argue lhat this represents a misuse
of scarce resources, but it could also bc argued rhat compctjtion
among the large companies results in grcater choice for consumcrs.
Firms undertake all kinds of behaviour to guard and extend thcir
markcl share. This serves to incrcase the barriers to entry to new
Iirrns. Many rivalries among lirrns in oligopolies are wcll known
nationally and inlernationally, Ior example Coke and pcpsi, or Adidas
and Nike. However, many ol the branded consumcr goods that we
purchase are prodrrced in oligopolies and wc night have no iriea that
there are actually just a few companics dominating the markct. A
walk down a supermarket aisle of washing powders might suggest a
vast number ol cornpeting companies when, in reality, the majorir)
of the brands arc produced by just two companies-Unilever and
Procter & Gamble. Thcsc two giant multinationals produce a vast
number of brands that competc with each other in a numbcr of
industries, for example, honte care products. pcrsonal hygiene,
health carc, and beauty products.
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Coca-Coia Company is the argest rnanufacturet
marketer, and dlstributor of non-alcoholic beverages in
the wodd. ALong with Pepsi and Cadbury Schweppes,
they make up a non-collusive ollgopoly that dominates
the world market in beverages.
2
to be quite stable in a non-collusive
Explarn why [irms in oligopolies engage,n nor-prrce
competition.
Il
O
norks]
Paper I, essay question
Distinguish between a collusive and a non-collusive
[10 norks]
oligopoly.
132
Find a copy of a consumer
magazine of any type (sporls,
computin& women's interest,
men's interest). By looking at
the advertisements in the
magazine, identify the
different ways that firms try to
differentiate their products.
Student workpoint IO-4
It 0 marks]
b
2
By referrinS to the lnternet
home pages of Unilever and
Procter & Camble, make a list
of 20 rival brands produced
by each of these giant
multinational companies.
Be inquisitive-investigate
oligopoly.
I a
t
Coca-Cola competes aggressively with Pepsi, which
aLso sells hundreds of brands around the world,
including Pepsi Cola, l\,4ountain DeW 7-Up, and
Tropicana. The intensity and the strategic nature of the
competition betlveen these tu/o giants is apparent:
they have both hired world famous celebrities to
advertise their products, they have be-.n rivals in
getting fast food restaurants to se I their prodlcts
exclusively, they try to match each other brand for
brand in getting new products on the market, and they
compete heavily to Saln the sponsorship of large
national and international events that put their brand
names into the llmelight.
EXAMINATION QUESTIONS
Paper l, paft (a) questions
Explain why prices tend
Be an inquirer
Limca in lndia, Kochakaden Tea in Japan, lnka Cola ln
Peru, Cepjta Nectars ln Argentina, and Citra in Zambia.
With the intense pace of globalisatlon, which makes
it easier for multinational companies to operate
businesses in foreign countries, Coca Cola has been
able to acquire brands from all around the world. lt now
has nearly 400 different brand names, selling drinks in
around 200 different countries. lt produces energy
drinks, juices, carbonated soft drinks, sports drinks, lced
teas and coffees, and bottled water. Some more famous
brand names include the range of colas, l\/inute Maid,
Five-Alive, Powerade, Fanta, Sprite, Nestea, Lemon,Lime
I
Student workpoint lO.t
Evaluate the view that governments should maintain
Find out the name of the anti
trust authority jn your country or
another country of your choice
and produce a brief report on
one case that it has investigated
in the Last year Include a
summary of who was involved,
what the charges were, and
what, if any, were the outcomes.
strong policies to control collusive behaviour by oligopolies. [t 5 norks]
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