Monopolistic Competition

Monopolistic Competition

The last 'topic' has covered the two most unrealistic market structures. Eachof them was at one of the two extremes of the spectrum. The first assumed infinite competition, and the other assumed no 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 these two extremes. This 'topic' will look at two of the models most regularly used by economists to try and explain the way firms actually behave in the real world. Monopolistic competition is closer in character to perfect competition and Oligopoly is closer to monopoly.

As with the last two market structures, it is important to state the assumptions before we get going.

  1. Numbers: 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. Ease of entry: This one is about barriers to entry. We assume that there is total freedom of entry into and exit from the market. There are no barriers to entry or exit (just like perfect competition).
  3. Knowledge: 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. Product: 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 non-homogenous.
  5. Maximising assumption: 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. Mobility of factors: 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. Price takers: 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.

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.

Textbooks often cite retailing as an example. Although the industry of food retailing, for example, is becoming more oligopolistic by the day (Tesco, Sainsbury's, Waitrose and Asda now dominate), there are still a large numberof 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. Do you think this is a good example?

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 assumption, basically.

Monopolistic Competition

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 P1 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.

Monopolistic Competition

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.

In the long run, all monopolistically competitive firms earn only normal profit. The reason for this will be explained after a quick lesson on how to draw this deceptively difficult diagram.

Monopolistic Competition

Students often draw this diagram incorrectly. 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 two red lines. 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). One accurate diagram!

Monopolistic Competition

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 (AR1 moves towards AR2). Firms will keep entering while there is super normal profit to take advantage of. This process will stop once all firms in the industry are earning only normal profit.

The lines AR1 and MR1 are the short run revenue curves. As explained above, the additional products that are introduced onto the market by new firms cause every existing firm's demand curve to shift to the left until every firm earns only normal profits. So AR1 shifts to AR2, with the corresponding MR curves shifting with them. At this point, AR = AC and only normal profit is being earned. There is no incentive for any firm to enter or leave the industry. We have a state of rest, or equilibrium.

Monopolistic Competition

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. This is illustrated by the shift of the green AR curve (AR1)to the right until it reaches the black AR curve (AR2). 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.

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?

Monopolistic Competition
Monopolistic Competition

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.