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Monopolistic Competition is a market structure which combines elements of monopoly and competitive markets. Essentially a monopolistic competitive market is one with freedom of entry and exit, but firms are able to differentiate their products. Therefore, they have an inelastic demand curve and so they can set prices. However, because there is freedom of entry, supernormal profits will encourage more firms to enter the market leading to normal profits in the long term.
* A monopolistic competitive industry has the following features:
* Product differentiation
* Many firms
* Free entry and exit in the long run
* Independent decision making
* Market Power
* Buyers and Sellers do not have perfect information (Imperfect Information)
* Diagram Monopolistic Competition Short Run
Short-run equilibrium of the firm under monopolistic competition: The firm maximizes its profits and produces a quantity where the firm’s marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.
* Monopolistic Competition Long Run
Long-run equilibrium of the firm under monopolistic competition: The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit.
MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of demand between goods in such a market is positive. In fact, the XED would be high. MC goods are best described as close but imperfect substitutes. The goods perform the same basic functions but have differences in qualities such as type, style, quality, reputation, appearance, and location that tend to distinguish them from each other. For example, the basic function of motor vehicles is basically the same – to move people and objects from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles such as motor scooters, motor cycles, trucks, cars and SUVs and many variations even within these categories.
There are many firms in each MC product group and many firms on the side lines prepared to enter the market. A product group is a “collection of similar products”. The fact that there are “many firms” gives each MC firm the freedom to set prices without engaging in strategic decision making regarding the prices of other firms and each firm’s actions have a negligible impact on the market. For example, a firm could cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors. How many firms will an MC market structure support at market equilibrium? The answer depends on factors such as fixed costs, economies of scale and the degree of product differentiation. For example, the higher the fixed costs, the fewer firms the market will support. Also the greater the degree of product differentiation – the more the firm can separate itself from the pack – the fewer firms there will be at market equilibrium.
Free entry and exit:
In the long run there is free entry and exit. There are numerous firms waiting to enter the market each with its own “unique” product or in pursuit of positive profits and any firm unable to cover its costs can leave the market without incurring liquidation costs. This assumption implies that there are low startup costs, no sunk costs and no exit costs. The cost of entering and exit is very low.
Independent decision making:
Each MC firm independently sets the terms of exchange for its product. The firm gives no consideration to what effect its decision may have on competitors. The theory is that any action will have such a negligible effect on the overall market demand that an MC firm can act without fear of prompting heightened competition. In other words each firm feels free to set prices as if it were a monopoly rather than an oligopoly.
MC firms have some degree of market power. Market power means that the firm has control over the terms and conditions of exchange. An MC firm can raise its prices without losing all its customers. The firm can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC firm’s market power is not barriers to entry since they are low. Rather, an MC firm has market power because it has relatively few competitors, those competitors do not engage in strategic decision making and the firm’s sells differentiated product. Market power also means that an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although not “flat”.
There are two sources of inefficiency in the MC market structure. First, at its optimum output the firm charges a price that exceeds marginal costs, The MC firm maximizes profits where p = MC. Since the MC firm’s demand curve is downward sloping this means that the firm will be charging a price that exceeds marginal costs. The monopoly power possessed by an MC firm means that at its profit maximizing level of production there will be a net loss of consumer (and producer) surplus.
The second source of inefficiency is the fact that MC firms operate with excess capacity. That is, the MC firm’s profit maximizing output is less than the output associated with minimum average cost. Both a PC and MC firm will operate at a point where demand or price equals average cost. For a PC firm this equilibrium condition occurs where the perfectly elastic demand curve equals minimum average cost. A MC firm’s demand curve is not flat but is downward sloping. Thus in the long run the demand curve will be tangential to the long run average cost curve at a point to the left of its minimum. The result is excess capacity.
While monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition far exceed the benefits of such regulation. However, it would not have to regulate every product and every firm just the most important ones. That alone would be an improvement on the current situation. A monopolistically competitive firm might be said to be marginally inefficient because the firm produces at an output where average total cost is not a minimum. A monopolistically competitive market is productively inefficient market structure because marginal cost is less than price in the long run. However, monopolistically competitive markets are allocatively efficient. Product differentiation increases total utility by better meeting people’s wants than homogenous products in a perfectly competitive market.
Another concern is that monopolistic competition fosters advertising and the creation of brand names. Advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. Defenders of advertising dispute this, arguing that brand names can represent a guarantee of quality and that advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands. There are unique information and information processing costs associated with selecting a brand in a monopolistically competitive environment. In a monopoly market, the consumer is faced with a single brand, making information gathering relatively inexpensive.
In a perfectly competitive industry, the consumer is faced with many brands, but because the brands are virtually identical information gathering is also relatively inexpensive. In a monopolistically competitive market, the consumer must collect and process information on a large number of different brands to be able to select the best of them. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand instead of a randomly selected brand. The result is that the consumer is confused. Some brands gain prestige value and can extract an additional price for that. Evidence suggests that consumers use information obtained from advertising not only to assess the single brand advertised, but also to infer the possible existence of brands that the consumer has, heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised brand.
In many U.S. markets, producers practice product differentiation by altering the physical composition of products, using special packaging, or simply claiming to have superior products based on brand images or advertising. Toothpastes, toilet papers, computer software and operating systems are examples of differentiated products. Corporate business profits reached $1.66 trillion per annum and 28% of it was obtained in the financial sector. This is not a trivial amount. In other words, the long-run never arrived for these firms.
Pricing decisions tend to be the most important decisions made by any firm in any kind of market structure. The concept of pricing has already been discussed in unit . The price is affected by the competitive structure of a market because the firm is an integral part of the market in which it operates. We have examined the two extreme markets viz. monopoly and perfect competition in the previous unit.
In this unit the focus is on monopolistic competition and oligopoly, which lie in between the two extremes and are therefore more applicable to real world situations. Monopolistic competition normally exists when the market has many sellers selling differentiated products, for example, retail trade, whereas oligopoly is said to be a stable form of a market where a few sellers operate in the market and each firm has a certain amount of share of the market and the firms recognize their dependence on each other. The features of monopolistic and oligopoly arediscussed in detail in this unit.
Edward Chamberlin, who developed the model of monopolistic competition, observed that in a market with large number of sellers, the products of individual firms are not at all homogeneous, for example, soaps used for personal wash. Each brand has a specific characteristic, be it packaging, fragrance, look etc.,though the composition remains the same. This is the reason that each brand is sold Pricing Decisions individually in the market. This shows that each brand is highly differentiated in the minds of the consumers. The effectiveness of the particular brand may be attributed to continuous usage and heavy advertising. As defined by Joe S.Bain ‘Monopolistic competition is found in the industry where there are a large number of sellers, selling differentiated but close substitute products’. Take the example of Liril and Cinthol. Both are soaps for personal care but the brands are different. Under monopolistic competition, the firm has some freedom to fix the price i.e. because of differentiation a firm will not lose all customers when it increases its price.
Monopolistic competition is said to be the combination of perfect competition as well as monopoly because it has the features of both perfect competition and monopoly. It is closer in spirit to a perfectly competitive market, but because of product differentiation, firms have some control over price. The characteristic features of monopolistic competition are as follows: A large number of sellers: Monopolistic market has a large number of sellers of a product but each seller acts independently and has no influence on others. A large number of buyers: Just like the sellers, the market has a large number of buyers of a product and each buyer acts independently.
Sufficient Knowledge: The buyers have sufficient knowledge about the product to be purchased and have a number of options available to choose from. For example, we have a number of petrol pumps in the city. Now it depends on the buyer and the ease with which s/he will get the petrol decides the location of the petrol pump. Here accessibility is likely to be an important factor. Therefore, the buyer will go to the petrol pump where s/he feels comfortable and gets the petrol filled in the vehicle easily. Differentiated Products: The monopolistic market categorically offers differentiated products, though the difference in products is marginal, for example, toothpaste.
Free Entry and Exit: In monopolistic competition, entry and exit are quite easy and the buyers and sellers are free to enter and exit the market at their own will.
Nature of the Demand Curve
The demand curve of the monopolistic competition has the following characteristics: Less than perfectly elastic: In monopolistic competition, no single firm dominates the industry and due to product differentiation, the product of each firm seems to be a close substitute, though not a perfect substitute for the products of the competitors. Due to this, the firm in question has high elasticity of demand. Demand curve slopes downward: In monopolistic competition, the demand curve facing the firm slopes downward due to the varied tastes and preferences of consumers attached to the products of specific sellers. This implies that the demand curve is not perfectly elastic.
PRICE AND OUTPUT DETERMINATION INSHORT RUN
In monopolistic competition, every firm has a certain degree of monopoly power i.e.every firm can take initiative to set a price. Here, the products are similar but notidentical, therefore there can never be a unique price but the prices will be in agroup reflecting the consumers’ tastes and preferences for differentiated products.In this case the price of the product of the firm is determined by its cost function,demand, its objective and certain government regulations, if there are any. As the price of a particular product of a firm reduces, it attracts customers from its rival groups (as defined by Chamberlin).
Say for example, if ‘Samsung’ TV reduces its price by a substantial amount or offers discount, then the customers from the rival group who have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung’ TV sets. As discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes downwards. The market has many firms selling similar products, therefore the firm’s output is quite small as compared to the total quantity sold in the market and so its price and output decisions go unnoticed. Therefore, every firm acts independently and for a given demand curve, marginal revenue curve and cost curves, the firm maximizes profit or minimizes loss when marginal revenue is equal to marginal cost. Producing an output of Q selling at price P maximizes the profits of the firm.