Download Monopolistic Competition

Monopolistic competition
You have probably realised from your experience of real life that just about every
market and industry in the UK falls somewhere in between the two extremes of
perfect competition and monopoly. Monopolistic competition involves many small(ish)
competing firms – none of which have any real market power.
The assumptions
1.
. In a monopolistically competitive market, there are many
buyers and many sellers. This is similar to perfect competition, except
that the numbers are not infinite. The market is still very competitive.
2.
. This one is about barriers to entry. We assume that
there is total freedom of entry into and exit from the market in the long
run. There are no barriers to entry or exit (just like perfect competition).
3.
. In a monopolistically competitive market, it is assumed
that both buyers and sellers have perfect knowledge, about prices in
particular. Buyers and sellers know the exact price of the product
charged by all firms at all times. This means that there are no search
costs for consumers (searching for the best price). Again, this is the
same as for perfect competition.
4.
. This is the big difference between monopolistic competition
and perfect competition. Whereas in perfect competition, the product sold
by the numerous firms in the market is homogenous, in monopolistic
competition the products offered are similar but differentiated, or nonhomogenous.
5.
. All firms aim to maximise their profits. That is
their sole objective. Buyers aim to maximise their welfare through their
purchases (the same as with perfect competition).
6.
. It is assumed that all of the factors of
production are perfectly mobile. If they are not being used as efficiently
as they could, they will instantly move to where they will be best used
without any restrictions. Again, the same as perfect competition.
7.
. Unlike firms in perfectly competitive markets,
monopolistically competitive firms do have a small amount of control
over the price they charge. Their demand curve is not perfectly elastic,
but it is relatively elastic. In other words, the demand curve is very flat,
but not horizontal. Remember that the products are slightly different, but
basically very similar. This means that each firm faces a lot of substitutes,
so the elasticity of demand is very high.
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These assumptions are very similar to those used in perfect competition. There are
two main differences. First, though there are a very large number of firms, the
number is not infinite. Each firm does have a very small market share and,
importantly, they still all act independently of each other. Secondly, the product is not
homogenous. This means that there is a possibility of firms advertising in this market
structure to highlight the slight differences in their product.
Are there any examples in the real world?
Textbooks often site retailing as an example. Although the industry of food retailing,
for example, is very oligopolistic (Tesco, Sainsbury’s, Morissons and Asda now
dominate), there are still a large number of small ‘one man’ stores that can survive
with a little bit of control over their price (although they are dying out). This is
because they offer something slightly different – personal service. The same is true
in the market for hardware products. Wickes, B&Q et al dominate, but there is still a
niche for the small local shop.
Another textbook example is the hotel industry. There are a lot of big hotel chains in
the UK, but there are also thousands of independent hotels where the owner lives on
the premises and probably does not own a second hotel. Think about the
assumptions above. Other examples of monopolistically competitive industries
include “Bed and Breakfast”, curry houses, newsagents and fish and chip shops.
Short run equilibrium output
For the diagram below, we do have to assume that the quality of the product
remains unchanged, and that the level of advertising is chosen and fixed in the short
run. The ceteris paribus (other things remaining equal) assumption, basically.
The diagram above shows a firm in a monopolistically competitive industry making
super normal profits in the short run. The diagram is exactly the same as the one for
the monopolist; the firm maximises profit by setting MC = MR giving price P 1 and
quantity Q1. The one difference is that that the AR (the demand curve) and MR
curves are much flatter. Remember that monopolistically competitive firms face a lot
of competition and, therefore, the demand for their product is very elastic. The firms
are not price takers, but they do have very little power.
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Just like with all the other market structures, monopolistically competitive firms can
make losses as well as profits in the short run. As you can see in the diagram above,
the AC curve is above the very flat AR curve, and so the firm is bound to make a
loss, even though it tries to minimise losses by following the condition MC = MR.
Long run equilibrium
In the long run, all monopolistically competitive firms earn only normal profit, as
shown on the diagram below :
The diagram above is often drawn incorrectly by students. The AC curve must be
tangential to (just touching) the AR curve. Also, the MC curve must cut the AC curve
at its lowest point (which always happens). The lowest point of the AC must be to
the right of the tangential point because it is sitting on a slope (albeit a very flat one).
The best way to get this right is to draw the AR curve, then the MR curve and then
the tangential AC curve. Then draw the horizontal line across to the price, P 1, and the
vertical line down to the quantity, Q1. You can now see where the MC curve has to
cut the MR curve (the maximising condition at point A). It is much easier, now, to
draw the MC curve in such a way as to go through point A and point B (the lowest
point on the AC curve).
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The move from short run to long run is very similar to perfect competition. The reason
for this is that the assumption about barriers is the same. There are no barriers to
entry or exit. This means that new firms will be attracted by any super normal profit.
The addition of new, slightly different, products onto the market will mean that all
existing firms will find their demand curves shift slightly to the left. This will keep
happening as long as firms keep entering. Firms will keep entering while there is
super normal profit to take advantage of. This process will stop once the abnormal
profits have been “competed” away and all firms in the industry are earning only
normal profit. There is no longer any incentive for a firm to enter the industry. We
have a state of rest, or equilibrium.
The situation is the same when firms are making a loss in the short run. Firms cannot
sustain losses into the long run, so some of the existing firms decide to leave (no
barriers to exit, remember). This will cause the demand curve for each firm that stays
to shift to the right, as they now have less competition. Firms will keep exiting while
they are making losses. This process will stop once the losses have disappeared and
all firms in the industry are earning only normal profit. There is no longer any reason
for a firm to exit the industry. We have a state of rest, or equilibrium.
At this point there will be no incentive for any firm to enter or leave the industry. We
have a state of rest, or equilibrium.
Comparisons with the efficient structure of perfect competition
In the long run, firms in both perfectly competitive markets and monopolistically
competitive markets earn only normal profits. But which market structure is the most
efficient?
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In the diagrams above, you can see the long run equilibrium situations for a perfectly
competitive firm (on the left) and a monopolistically competitive firm (on the right).
The perfectly competitive firm is both allocatively efficient (because price = MC)
and productively efficient (because the equilibrium output occurs at a level where
MC = AC; the bottom of the AC curve).
If you look at the other diagram, though, you see that the monopolistically competitive
firm is neither allocatively efficient (this occurs at output level Q3) nor productively
efficient (which occurs at output level Q4). The firm’s level of production is too low to
be efficient in either sense. There are too many firms producing too little output.
The inventor of this model, someone called Edward Chamberlain, did argue, though,
that the cost to society of this inefficiency is probably made up for by the increased
choice and variety due to the differentiated products.
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