Studied by 0 peopleWhat is monopolistic competition?
Monopolistic competition is market structure which combines elements of monopoly and competitive markets.
It is a form of imperfect competition.
How is monopolistic competition similar to perfect competition?
It is like perfect competition but more realistic, as products are differentiated. Product differentiation means businesses have some price-setting power with a downward sloping AR but also high XED.
Monopolistic competition is like the rebellious cousin of perfect competition - it's got some similar traits, but with a twist.
What are features of a monopolistic competitive market?
Many firms, but not as many as in perfect competition.
Products are similar, but not identical - they have some differentiation, like branding or slight differences in features.
Firms have some control over price, but not as much as in a pure monopoly.
Entry and exit are somewhat easier than in monopolies, but not as easy as in perfect competition.
Firms make normal profits in the long run but could make supernormal profits in the short term
Firms are allocatively and productively inefficient.
What are examples of forms product differentiation can come in?
Branding and marketing: Companies can differentiate their products through branding and advertising, making them more attractive to consumers. Think of Nike's swoosh logo and "Just Do It" slogan, or Apple's sleek design and focus on user experience.
Product features: Adding features to a product can make it stand out from competitors. For example, Tesla's electric cars have unique features like self-driving capabilities and a large touch screen display.
Quality: Higher quality can be a differentiator.
Where do firms produce to profit maximise?
In order to maximise profit, firms in monopolistic competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)
How does the firm have some market power?
The firm does have some market power and is able to influence the price & quantity
The firm is a price maker
This is due to the fact that they have a differentiated product that is desirable by certain consumers
What profit can be made in the short run?
The firm can make supernormal profit in the short-run
What profit can be made in the long run?
In the long-run, the firm will return to a long-run equilibrium position in which they make normal profiT
Why does a firm return to long run equilibrium position?
This is due to inability to defend against new competitors who enter the market & copy the products of existing sellers
Firms will attempt to find new ways to differentiate their product to prolong the period of supernormal profit e.g. a barber shop may add in a pool table & beer fridge for their customers to enjoy thus making them different from the competition (for a period of time)
What is the diagram like for monopolistic competition in the short run?
In the short run, the diagram for monopolistic competition is the same as for a monopoly.
Why is the AR and MR curve downward sloping?
The AR curve is the demand curve of the firm & it is downward sloping
The firm has some market power due to the level of product differentiation that exists
To sell an additional unit of output, the firm will have to decrease its price
The marginal revenue (MR) curve will fall twice as quickly as the AR
What are short run dynamics in monopolistic competition?
Many producers and many consumers - the industry concentration ratio is low
Non-price competition is strong and lots of consumer switching takes place
Barriers to entry and exit are low - allows producers to respond to profit signals
Draw a diagram showing short run profit maximisation and explain it.
The firm produces at the profit maximisation level of output where MC = MR (Q1)
At this level the AR (P1) > AC (C1)
The firm is making supernormal profit
Draw a diagram showing short run losses and explain it.
Companies in monopolistic competition can also incur economic losses in the short run. They still produce equilibrium output at a point where MR equals MC in which losses are minimized.
The firm produces at the profit maximisation level of output where MC = MR (QE)
At this level of output, the AR (PE) < AC (C1)
How does a firm move from supernormal (in SR) to normal profit (in LR)?
If firms in monop. competition make sup. profit in SR, new entrants are attracted to the industry & the number of sellers increases
Are incentivised by opportunity to make sup. profit
There are low barriers to entry
It is easy to join the industry
Sup. profit will be eroded & the firm will return to the long-run equilibrium position of making normal profit
How does a firm move from losses (in SR) to normal profit (in LR)?
If firms in monop. competition make losses in SR, some will shut down
Shut down rule will determine which firms shut down
Are low barriers to exit, so it is easy to leave industry
For remaining firms, losses will be eliminated & the firm will return to the LR equilibrium position of making normal profit
What does sup. profit do to other firms?
Supernormal profits attract new suppliers with differentiated products into the market. This dilutes the market share of existing products causing an inward shift of AR and MR.
What is the principle of minimum differentiation?
Be aware of the principle of minimum differentiation - entering market with similar products makes it easier for consumers to switch (as there are many close substitutes available).
How is long run price and output determined in monopolistic competition?
Draw the AR curve. Draw it so it is tangential to AC - in the long run equilibrium, average revenue is tangential to AC - meaning normal profits are being made as P=AC.
Then find the output (Q2)
Draw the MR last so it cuts MC at output Q2
This is then a profit max equilibrium (MC=MR)
Also, sales max since AR=AC
Draw and explain a diagram of a firm in the long run.
Is making normal profit. AR (P1) = AC at profit maximisation level of output (Q1)
The firm is initially producing at the profit maximisation level of output where MC=MR (Q1)
At this level of output P1 = AC & the firm is making normal profit
How does the diagram adjust to long run equilibrium in MC?
No barriers to entry and exit of firms in LR
Sup. profit attracts new suppliers offering new differentiated products
As more firms enter the market, the D curve for any existing firm shifts to the left (market saturation)
D curve moves to the left until it is tangential to the AC curve. (NB: MR curve will shift inwards as well)
At LR equilibrium, the firm is at its profit-max. level of output, but making only normal profit (AR-AC)
Are firms allocatively efficient?
The above diagrams show a price set above marginal cost
Prices still above marginal cost but highly price elastic demand reduces the pricing power of competitive firms.
Are firms productively efficient?
The above diagram shows a firm not producing on the lowest point of AC curve
Saturation of market with many differentiated products may limit the scope for economies of scale (lower LRAC)
Are firms dynamically efficient?
This is possible as firms have profit to invest in reserach and development.
Strong non-price competition can see plenty of product innovation
Limited profits can hold this back.
Are firms x-efficient?
This is possible as the firms does face competitive pressures to cut costs and provide better products.
Do firms have social efficiency?
Heavy spending on packaging might be damaging - contributing to increased product waste sent to landfill (external costs)
What can there be trade offs between?
There can be trade offs between different types of economic efficiency
An increase in consumer welfare doesn’t necessarily improve our welfare
What does the new trade theory place importance on?
New trade theory places importance on model of MC for explaining trends in trade patterns.
What does new trade theory suggest about differentiation?
Suggests key element of product development is drive for product differentiation – creating strong brands and new features for products.
Thus, specialisation doesn’t need to be based on traditional theories of comparative advantage, but we can have countries both importing and exporting same good.
E.g. we import Italian fashion labels + export British fashion labels. To consumers, importance is choice of goods.
What does new trade theory suggest about being early entrant?
Firms who have advantage of being early entrant can become a dominant firm in market, because the 1st firms gain substantial economies of scale meaning new firms can’t compete against incumbent firms.
Means that in these global industries with v. large economies of scale, there is likely to be limited competition, with market dominated by early firms who entered, leading to a form of MC.
What does new trade theory suggest about countries that will produce goods?
Means most lucrative industries often dominated in capital-intensive countries, who were 1st to develop these industries. Thus, being 1st firm to reach industrial maturity gives v. strong competitive advantage. (some may say unfair advantage)
Means poorer, developing economies may struggle to ever develop certain industries as they lag too far behind economies of scale enjoyed in developed world. This is not due to any intrinsic comparative advantage, but more economies of scale developed firms already have.
What does new trade theory suggest about government regulation?
Suggests govts might have role to play in promoting new industries and supporting growth of key industries.
Developing economy may need tariff protection and domestic subsidy to encourage creation of capital-intensive industries. If industry gets support for few years, it will be able to exploit economies of scale and then be competitive without govt support.
This is similar to arguments surrounding infant industries.
What are the problems of this government intervention?
This idea of govt supporting new industries is controversial. Many economists say that it is likely to create other problems such as
The govt is likely to have poor information about which industry to support and how to go about it.
It creates a tendency for powerful vested business interests which rely on state support. This state support may encourage inefficiency in the long-term.
How does new trade theory link to gravity theory?
Gravity theory suggests trade is influenced by countries geographical proximity and similarities in terms of culture and economic development.
It suggests neighbouring countries are more likely to trade with each other.
Gravity theory is element of ‘New trade theory’ as it emphasis factors which influence trade – other than traditional ‘comparative advantage’
How are low barriers an advantage?
Low barriers to entry mean that there is intense competition between firms – leading to more choice of product for consumers.
Means markets are relatively contestable.
Eval: Extensive choice is not always a benefit for consumers – people have bounded rationality and may not make optimal decisions if there is a bewildering choice
How is alloc. efficiency an advantage?
In monopolistic competition, prices are kept closer to marginal cost leading to improved allocative efficiency.
Eval: Although competition keeps prices low, the saturation of products may lead to firms not exploiting economies of scale, this leads to a loss of productive efficiency
How is innovation an advantage?
There will be a high level of innovation causing an improvement in dynamic efficiency.
How is efficiency an advantage?
The market is more efficient than monopoly but less efficient than perfect competition – less allocatively and less productively efficient.
However, they may be dynamically efficient, innovative in terms of new production processes or new products.
E.g. retailers often constantly have to develop new ways to attract and retain local custom.
How is differentiation an advantage?
Differentiation creates diversity, choice and utility.
Eval: Product differentiation through excessive packaging leads to increased wastage and external costs e.g. from disposing plastic.
Consumers tend to benefit from lower prices & enhanced product choices. But there might be limited opportunities for suppliers to exploit economies of scale.
How is differentiation a disadvantage?
Some differentiation does not create utility but generates unnecessary waste, such as excess packaging. Advertising may also be considered wasteful, though most is informative rather than persuasive.
How is alloc. efficiency a disadvantage?
As diagram illustrates, assuming profit maximisation, there is allocative inefficiency in both the long and short run.
This is because price is above MC in both cases.
In the LR the firm is less allocatively inefficient, but it is still inefficient.
Is firm efficient?
The firm is allocatively and productively inefficient in both the long and short run.
Why are firms productively inefficient?
There is a tendency for excess capacity because firms can never fully exploit their fixed factors because mass production is difficult.
This means they are productively inefficient in both the long and short run.
However, this is may be outweighed by the advantages of diversity and choice
Draw a diagram showing how firms are ineffecient?
How can antitrust laws be a govt response?
Govts can enforce antitrust laws to prevent firms from engaging in anticompetitive behavior such as price-fixing, collusion, or monopolization.
Antitrust enforcement can involve breaking up monopolies or imposing fines on firms that engage in anticompetitive practices.
How can market regulation be a govt response?
Govts can regulate specific aspects of the market to promote competition.
E.g. may regulate entry barriers such as licensing requirements or zoning laws to prevent firms from monopolizing market.
How can consumer protection laws be a govt response?
Governments can enact consumer protection laws to ensure that firms provide accurate information to consumers about their products and services.
This can include regulations on advertising, labeling, and product safety standards.
How can price controls be a govt response?
In some cases, govts may impose price controls to prevent firms from charging excessively high prices or engaging in price gouging.
However, price controls must be carefully implemented to avoid unintended consequences such as shortages or reduced quality.
How can merger review be govt response?
Govts can review mergers and acquisitions to assess their potential impact on competition in the market.
They may block mergers that would result in a significant reduction in competition or impose conditions to mitigate anticompetitive effects.
How can subsidies and incentives be a govt response?
Govts can provide subsidies or incentives to encourage competition in monopolistically competitive markets.
E.g. they may offer grants or tax breaks to new entrants or firms that invest in innovation.
How can information disclosure be a govt response?
Govts can require firms to disclose information about their products, pricing, and business practices to consumers and competitors.
This transparency can help level the playing field and empower consumers to make informed choices.
How can regulatory agencies be a govt response?
Govts can establish regulatory agencies tasked with overseeing specific industries or sectors to ensure compliance with regulations and promote competition.
These agencies may have the authority to investigate complaints, enforce regulations, and impose sanctions on non-compliant firms.
What is the goal of govt regulation in MC markets?
Overall, goal of govt regulation in monopolistically competitive markets is to foster competition, protect consumers, and promote economic efficiency.
However, regulatory interventions must be carefully designed to balance these objectives while minimizing unintended consequences and distortions in the market.
How is differentiation a limit of the model?
Some firms will be better at brand differentiation and therefore, in the real world, they will be able to make supernormal profit.
How are substitutes of the model?
New firms will not be seen as a close substitute.
How is overlap with oligopoly a limit of the model?
There is considerable overlap with oligopoly – except the model of monopolistic competition assumes no barriers to entry. In the real world, there are likely to be at least some barriers to entry
How is brand loyalty a limit of the model?
If a firm has strong brand loyalty and product differentiation – this itself becomes a barrier to entry. A new firm can’t easily capture the brand loyalty.
How is profit a limit of the model?
Many industries, we may describe as monopolistically competitive are very profitable, so the assumption of normal profits is too simplistic.
How are restaurants a real life example?
Restaurants – restaurants compete on quality of food as much as price. Product differentiation is a key element of the business. There are relatively low barriers to entry in setting up a new restaurant.
How are hairdressers a real life example?
Hairdressers. A service which will give firms a reputation for the quality of their hair-cutting.
How is clothing a real life example?
Clothing. Designer label clothes are about the brand and product differentiation
How are programmes a real life example?
TV programmes – globalisation has increased the diversity of tv programmes from networks around the world. Consumers can choose between domestic channels but also imports from other countries and new services, such as Netflix.
What are characteristics of monopolistic completion?
many buyers and sellers
Slightly differentiated goods
firms are price markers (only slightly as there are many other firms)
Price elastic demand
Low barriers to entry/exit
Good information
Non-price competition
Firms are profit maximisers
What are examples of monopolistic competitive markets?
Clothing
Taxis
Fast food / Restaurants
Hair salons
Bars / Night Clubs
What is the diagram for monopolistic competition in the short run the same as monopoly?
Firms are selling something relatively unique
Firms have price making ability
They are going to profit maximise
Going to end up with v. similar outcomes to monopoly
Why can firms in monopolistic competition make supernormal profit in the short run?
exploiting their price making power given the fact that they are selling a unique good
Why can firms enter the market (when incentivised by supernormal profit making in the short run)?
Because they are low barriers to entry and exit, and good information about what is happening in the market
What will the entry of new firms do to the demand curve for indivual firms?
Demand curve (AR curve) will shift left until normal profit is made (where AR=AC)
How to draw long run diagram of monopolistic competition?
Draw AR & MR curves (they are the same as in the short run)
Draw MC (same as in the short run)
Add on the price and quantity profit max
Draw AC, making sure it touches AR where normal profit is made, and that MC hits the minimum point of AC
Are firms allocatively efficient (in the long run)?
No, Price is greater than Marginal Cost
Means consumers are exploited (at least in theory)
Output is restricted
Choices are restricted
Why is it more important to consider efficiency in the long run?
Because it is our stable position over time
Are firms productively efficient (in the long run)?
no, as we are not at the minimum point on the AC curve
Voluntarily forgoing economies of scale
Another reason for prices being higher in the market is because costs are not being minimised
Are firms dynamically efficient (in the long run)?
no, as there is no long run supernormal profit being made
There isn’t enough profit to be reinvested back into the company
How efficient is it compared to Perfect Comp?
in PC: allocative and productive efficiency is attained v. not in MC
In PC: is not dynamically efficient either
How efficient is it compared to Monopoly?
in M: also not prod. or alloc. efficient either
In M: is dynamically efficient v. not in MC
In theory, MC is as bad as monopoly in terms of not being allocatively efficient. Is this true?
is some decent competition in this market which means that the price making ability of these firms is lower and so the price exploitation is not going to be anywhere as near as bad as a monopoly, the loss of consumer surplus is not going to be anywhere near as bad
so we can say that compared to a monopoly, nowhere near as bad
In theory, MC is worse that PC in terms of not being allocatively efficient. Is this true?
In PC, there are homogenous goods. Is that what consumers desire? We can argue no, especially in many markets like clothing and restaurants - here we don’t want homogenous goods, we like differentiation. And maybe we consumers are willing to pay a little bit more, we’re willing to erode a little bit of our consumer surplus for that.
In which case, actually this allocative inefficiency is not a bad thing, it’s quite desirable - especially when the exploitation isn’t anywhere near as bad as you might think given the fact that there are good substitutes available
Are firms in MC actually as bad as monopolies in terms of productive efficiency?
compared to monopoly, nowhere near as bad
There are good substitutes - firms can’t afford to forgo economies of scale to the same extent as monopolies and charge the higher prices
How can you evaluate the efficiency of PC compared to MC?
in PC there might not be very many economies of scale at all, whereas in MC there are - so any economies of scale that are being exploited might be to a greater extent than in PC and therefore prices might actually still be lower than in PC
Productive inefficiency in MC might be due to the product differentiation demands of consumers. Our desire for variety might make it harder to exploit economies of scale - much harder if you’re producing a wide range of different goods as opposed to just 1 good
Is it necessarily true that there is no dynamic efficiency in MC?
could argue that if short run sup. profits are enough to reinvest we can get dynamic efficiency
also (maybe a better argument), could argue that in a v. competitive market, we can still get dynamic efficiency even if normal profits are being reinvested - it could be just part of competition in the market for firms to have to reinvest e.g. if clothing firms don’t reinvest and bring in new fashion lines as new seasons come along they’re going to fall behind significantly - so even if the extent of the reinvestment is small, we still see dynamic efficiency in MC markets, especially if reinvestment is part of the competition, but even if not, firms may reinvest to try and get ahead of rivals even using very small scale profits to do so
Is MC better at dynamic efficiency than in PC and monopoly ?
better than PC - as there could be argued to be dynamic efficiency in MC
In monopoly (where it might not occur - see many arguments for dynamic eff. not to occur in monopoly) you could argue you are more likely to get it in MC
What can we use these evaluations to argue?
to argue that MC is actually the best market structure
Use them to overcome the theoretical inefficiencies that we get from the diagrams
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