5.6 - Monopolistic competition

What are features of monopolistic competition?

- Firms are price makers

- Large number of firms

- Low barriers to entry

- Low exit costs

- Knowledge is not perfect but widespread

- Firms objective is to maximise profit

In what ways does monopolistic competition resemble perfect competition?

- As in perfect competition, there are a large number of firms in the market

- In the long run there are no barriers to entry or exit

- As a result, the entry of new firms, attracted by short run abnormal profits, bringing down the price each firm can charge until only normal profits are made in the long run

How does monopolistic competition resemble pure monopoly?

- Each firm faces a downward sloping demand curve. This results from the fact that each firm produces a slightly different product.

- Each firm's marginal revenue curve is below its average revenue curve, which of course is the demand curve for the firm's output

Short run profit maximisation in monopolistic competition shown on a diagram

(page 140) In monopolistic competition, the demand or average revenue curve represents demand for the goods produced by just one firm within the market rather than demand for the output of the whole market. And because the other firms within the market product partial though not perfect substitutes, the demand curve facing the firm is likely to be rather more elastic at the prices each firm may decide to set than would be the case in pure monopoly.

The profit maximisation level of output, Q1 is located below point A on the diagram, where MR=MC, and the abnormal profit made by the firm in the short run are shown by the rectangular area C1DBP1.

Long run profit maximisation in monopolistic competition shown on a diagram

(page 141) In the long run, the entry of new firms cause the AR curve facing an established firm to shift inward. The leftward shift may result from the introduction of new substitute products, attracting some customers away from the existing firms.

Long run profit maximisation is achieved when the AR curve just touches the firm's ATC curve, thereby removing the firm's abnormal profit. This is shown at point B immediately above level of output Q1. Since only normal profit is made, total sales revenue and total costs of production are both shown by the rectangle OQ1BP1.

How can monopolistic competition improve economic welfare?

Its argued that the number of differentiated products increases until the gain to consumers in choice from adding one more products to the market exactly equals the loss resulting from having to produce less of the existing products at a higher cost.

According to this argument, monopolistic competition does not necessarily result in economic waste. Consumers may prefer the wider choice available in monopolistic competition to ant improvement in productive efficiency that alternative market structures may provide.

How can advertising promote competition?

Informative advertising increases competition because it provides consumers and producers with useful information about goods and services which are available to buy, and about the different goods that different firms are producing.

How can advertising create a barrier to market entry?

Persuasive advertising often reduces competition by making the demand curve for a product less price elastic. Persuasive advertising tries to make people believed that a product is a must have product.

There is little information about the good provided. This goes hand in hand with saturation advertising which creates a barrier to entry as smaller firms cannot afford the minimum level of advertising.

What is price competition?

Price competition takes place when a firm reduces price in order to sell more of a good or service.

Increases sales can occur in two different ways.

- consumers switch from other markets where prices are higher and buy this good instead.

- consumers switch from buying similar goods from rival firms within the same market to but the good from the firm that has cut its price.

Why do competitive firms not like to use price competition?

It's often argued because it leads to self-defeating price wars which ultimately only benefit consumers.

However there are a number of ways in which firms undertake price competition, particularly in market dominated by just a few firms. Beside limit pricing and predatory pricing, firms may undertake special offer pricing.

What are the various forms of non price competition?

- Marketing competition, including obtaining exclusive outlets such as tied public houses and petrol stations through which breweries and oil companies sell their product

- The use of persuasive advertising, production differentiation, brand imaging, packaging, fashion, style and design

- Quality competition, including the provision of point of sale service and after sales service

Is monopolistic competition efficient?

- Inefficient compared to other markets

- Allocative efficiency not achieved in SR or LR as price is greater than MR

- Productive efficiency is not achieved in SR or LR as firms are not on the lowest point of AC

Examples of monopolistic competition?

- Restaurants who compete on the quality of food as much as price

- Hairdressers - a service which will give firms a reputation for the quality of their service

Limitations of monopolistic competition?

- Some firms will be better at brand differentiation and therefore will be able to make supernormal profit

- New firms will not be seen as a close substitute

- If a firm has a string brand loyalty, this creates a barrier to entry

- Many industries considered monopolistic competitive are very profitable so the assumption of normal profits is too simplistic

Key difference with pure monopoly?

In monopolistic competition, there are no barriers to entry. Therefore in the LR, the market will be competitive with firms making normal profit.

Key difference with perfect competition?

In monopolistic competition, firm do differentiate products, therefore, they are not price takers.