Monopolistic Competition in Market Dynamics

1. Monopolistic Competition Chapter 17

2. What we learn in this chapter? • Ch.13 established the cost structure of the firm as the unit of production in a market economy • Ch.14 looked at the equlibrium of the firm and of the market assuming perfect competition • Ch.15 studied the the causes and the implications of monopoly as theonly seller in a market • Ch.16 analysed oligopoly as the first case of imperfect competition • Ch. 17 deals with the second case of imperfect competition • Monopolistic competition refers to situations where a relatively large number of firms compete but with non-homogeneous products

3. Types of imperfect competition • We defined imperfect competition as the gray area between perfect competition and monopoly • Oligopoly corresponded to the situation when only few sellers each offering a similar or identical product as the others exist in the market • Monopolistic competion is the other case of imperfectly competitive markets • There are many firms but each sell a product that is similar but not identical • Monopolistic competition corresponds to markets that have some features of competition and some features of monopoly because of differentiated products

4. Attributes of monopolistic competition • Three characteristics of monopolistic competition • Many sellers: there are many sellers competing for the same group of customers • Product exemples: books, CDs, movies, computer games, restaurants, furniture, etc. • Product differentiation: Each firm has a slightly different product compared with other firms • Firms therefore face a downward sloping demand curve • Free entry or exit: there are no restrictions to entry and exit, therefore the number of firms in the market adjust until economic profits are zero.

5. Monopolistic competition in the short run • In the short run, the equilibrium of the monopolistic-ally competitive firm resembles that of a monopoly • In other words it follows the monopolist’s rule for profit maximisation • Cut production at the quantity when MR = MC • Go to the demand curve to find the selling price for that quantity • Therefore marginal cost will always be below price • But there is one difference with monopoly • The existence of profits depend on average total cost level at that quantity

6. Monopolistic competition in the short run Firm Makes a Profit Price MC ATC Price Average total cost Demand Profit MR 0 Profit- Quantity maximizing quantity

7. Loss- minimizing quantity Monopolistic competition in the short run Firm Makes Losses MC Price ATC Losses Average total cost Price Demand MR 0 Quantity

8. From short run to the long run • The long run equilibrium of the monopolistically competitive firm resembles perfect competition • The existence of profits or losses at the short run will determine the long run behaviour of the market • Short run profits encourage new firms to enter the market, meaning more supply of new products • Demand of incumbent firms fall and their demand curve shifts left, reducing prices and quantities • Short run losses imply the opposite • Some firms exit, therefore there is less supply and products increasing demand for remaining firms • Demand curve for remaining firms shifts right and profits increase

9. The long run equilibrium • The long run equilibrium of a market with mono-polistic competition is achieved by the entry and exit of firms depending on short term profits/losses • In the long run economics profits will be zero • The long run in equilibrium for monopolistic competition has elements from both perfect competition and monopoly • As in a monopoly price exceeds marginal cost • Downward sloping demand curve mean that MR curve is is below the demand curve and MR = MC • As in a competitive market price equals average cost • Because free entry and exit drive economic profits to zero

10. Short run loss and long run equilibrium Price MC ATC Demand MR 0 Quantity

11. Short run profit and long run equilibrium Price MC ATC Demand MR 0 Quantity

12. Monopolistic competitionin the long run Price MC ATC Demand MR 0 Long-run Profit-maximizing quantity Quantity

13. Monopolistic versus perfect competition: excess capacity • There are two noteworthy differences between monopolistic and perfect competition: excess capacity and mark-up • In perfect competition in the long run, firms produce at the point where ATC is minimised (efficient scale) • There is no excess capacity • In monopolistic competition in the long run firms produce output than the efficient scale where ATC is minimised • In other words, monopolistic competition implies excess capacity not only in the short run but also in the long run

14. Quantity produced = Efficient scale Excess capacity Monopolistically Competitive Firm Perfectly Competitive Firm Price Price MC MC ATC ATC P P = MC P = MR (demand curve) Excess capacity Demand Quantity Quantity Quantity produced Efficient scale

15. Mark-up over marginal cost • For a competitive firm, price equals marginal cost both in the short and long run due to the horizontal demand curve (price taker) P = AR = MR = MC • For a monopolistically competitive firm price exceeds marginal cost both in the short and long run due to downward sloping demand curve (price maker) P = AR > MR = MC • Mark-up means price exceeds marginal cost • Mark-up pricing implies that an extra unit sold at the posted price earns more profit for the firm • Profit volume depends on sale volume

16. Mark-up over marginal cost Monopolistically Competitive Firm Perfectly Competitive Firm Price Price MC MC Markup ATC ATC P P = MC P = MR (demand curve) Marginal cost MR Demand Quantity Quantity Quantity produced Quantity produced

17. Monopolistic competition and the welfare of society • Monopolistic competition is less desirable for society compared with perfect competition • First and foremost, it causes deadweight loss to the society due to the markup of price over marginal cost • Excess capacity in the long run implies unused scarce resources for the society • Regulation to achieve the equality of marginal cost and revenue is not practical because it involves interfering with the pricing decisions of all the firms with differentiated products • Even an efficient and non-corrupt public administra-tion may find this task impossible

18. Monopolistic competition and externalities • If the number of firms and products in a market is not “ideal”, the outcome of monopolistic competition will not be socially efficient • The variety of pruducts in the market can be too large or too small to be socially efficient • Too much or too little market entry cause positive or negative externalities • Externatilities of entry include product-variety externatility and business-stealing externality • These are subtle, hard to measure and hard to fix • There is no easy way public policy can improve the market outcome

19. Advertising and brand names • A good indicator of monopolistic competition in a market is the advertising effort made by firms to convince consumers of the superiority of their products and to obtain brand loyalty • The higher the brand loyalty of consumer, the less elastic will be the demand curve of the firm and therefore higher its mark-up and profits • A brand is also a guarantee of quality for the consumer when it is difficult to establish the quality of products just by sight • Brand names dominate many if not most consumer goods and service industries in the world • Brands are important assets for those firms

20. Debate over advertising • Advertising and its value to the economy is open to debate everywhere in the world • Critics of advertising and brand names contend that advertising help firms exploit consumers and reduce competition • Defenders argue that advertising provides information and increases competition by offering a greater variety of products and prices • Firms that sell highly differentiated consumer goods typically may spend up to 10 to 20 percent of sales revenue on advertising • In the US, total advertising spending stands at 2 % of revenues (100 billion $)

21. Case studies over advertising • Spending on advertising increases costs of firms • Do the consumers pay for it through higher prices? • Evidence must be searched in the real world • Research undertaken in the US compared two States, one with a ban on advertising for opticians, the other without such a ban • There was considerable difference in the average prices of eyeglasses in the two States • The State without advertising ban had lower prices despite the high cost of advertising • The State with the ban had higher prices because there was less competition among opticians • Benefits of competition outweight cost of advertising

22. Conclusion • Markets with monopolistic competitive are charac-terised by many firms producing differentiated products and freedom of entry/exit in the market • Differentiated products mean a downward sloping demand curve for the firm (price maker) • The short run equilibrium of a monopolitically competitive firm resembles that of a monopoly • Quantity to be produced is determined at the point where marginal revenue is equal to marginal cost • But there may or may not be economic profits depending on the value of average total cost • Short run profit and loss will result in new entries or exits from the market

23. Conclusion • Long run equilibrium is achieved when price equals average total cost • In the long-run equilibrium, monopolistically competitive markets produce with some excess capacity and each firm charges a price above marginal cost • The selling price of a monopolistically competitive market results in some deadweight losses and resource misallocations that regulation cannot practically remedy • Product differentiation forces firms to advertise and to establish brands in orter to increase profits • Advertising may increase competition