Monopolistic Competition

Define the term ‘Monopolistic competition’

A market structure in which there are many firms offering a similar product but with some product differentiation

Explain the characteristics of Monopolistic Competition

Large number of small firms: Each one is relatively small and can act independently of the market

There are low barriers to entry and exit: Firms can start-up or leave the industry with relative ease which increases the level of competition

The products are slightly differentiated: This structure exists as consumers have different desires. This means that the firm’s are price makers, but not to a significant degree as close substitutes exist so the firm faces a relatively elastic demand curve

Illustrate a firm in monopolistic competition making supernormal profits in the short-run

The firm does have some market power and is able to influence the price and quantity

The firm is a price maker given that they provide differentiated products that are desirable by certain consumers, and so faces a downwards sloping AR/Demand curve

In order to maximise profit, firms in monopolistic competition produce up to the level of output where MC=MR

Firms in monopolistic competition are able to make supernormal profit in the short-run of (P1-C1) x Q1

Illustrate a firm in monopolistic competition making normal profits in the long-run

In the short run, if a monopolistically competitive firm is making supernormal profit, it will incentivise new firms to enter the market as they are attracted by the idea of making supernormal profits

Given that there are low barriers to entry, firms can enter the industry with relative ease which increases the level of competition

For existing firms, this will decrease the demand for their goods and services, decreasing AR and MR

Supernormal profit will be eroded and potential suppliers outside the market will no longer enter the market because they can no longer make supernormal profit

The firm will return to the long-run equilibrium position of making normal profit

Illustrate a firm in monopolistic competition making normal profits in the long-run, following making a loss in the short-run

In the short run, if monopolistically competitive firm are making a loss, assuming that it is not making sufficient revenue to cover their variable costs, some will shut-down as it is making a loss on each unit sold.

Given that there are low barriers to exit, firms can exit the industry with relative ease which reduces the level of competition

For existing firms, this will increase the demand for their goods and services, increasing AR and MR

For the remaining firms, losses will be eliminated and the firm will return to the long-run equilibrium position of making normal profit

Allocative efficency

In a monopolistically competitive market, allocative efficency is not achieved given that price does not equal marginal cost in the long run. This means recourses are allocated in such a way that reduces consumer welfare, as output is restricted, price is high and choice is restricted. Overall, consumers are worse off.

Productive efficiency

In a monopolistically competitive market, productive efficency is not achieved given that the firm is not operating at the lowest possible average cost. This suggests that firms are voluntarily foregoing economies of scale since the firm restricting output, without full utilisation of its inputs which puts upwards pressure on the price of the good or service.

May be due to the product differentiation demands of consumers, as their desire for variety may make it more difficult for monopolistically competitive to exploit economies of scale. This is because a firm may be producing a wider range of goods as opposed to one product, and so may not be able to bulk buy to a large extent limiting purchasing economies of scale.

Dynamic efficency

In the short run, although firms may be statically inefficient in a monopolistically competitive market it may be dynamically efficient in the short-run which refers to when changing technology improves a firms productive potential. Given that in the short run, firms are making supernormal profits (P1-C1) X Q1 it gives them sufficient internal finance made available to them to reinvest into R&D and development of technological innovation. This means that consumers will be able to enjoy a wider variety of goods and services and reap the benefits of these new technological products, improving consumer welfare.

However, in evaluation, although it may be making supernormal profits in the short-run, in the long-run it is competed away to the point where firms are only making normal profits. This means that it may be dynamically inefficient in the long run, which refers to when changing technology improves a firms productive potential. Given that the firm is no longer making SNP’s it gives them insufficient internal finance made available too them to reinvest into R&D and development of technological innovation. This means that consumers wont be able to enjoy a wider variety of goods and services and reap the benefits of these new technological products, reducing consumer welfare further.

Alternatively, it wont internal finance made available to them to reinvest into R&D to suffice the improvement of its existing production process. This may be increased use of automation which is the use of technology and machines to perform assembly line work. This means that, it wont be able to reap the benefits of technical economies of scale and so wont be able to spread the cost of capital along more units of output, inhibiting the firms ability to reduce its LRAC and increase profits further. Therefore, given that the firm is dynamically inefficient this may lead to stagnant business growth

Evaluation

Degree of competition is high, limiting the extent of these firms pricing power and so the price exploitation of these consumers will be lower. Therefore, the loss of consumer surplus isn’t as high relative to other imperfectly competitive market structures such as monopolies.

Benefits consumers to a larger degree relative to perfect competition as consumers tend to desire slightly differentiated goods relatively to perfectly homogenous goods. Therefore, consumers may be willing and able to pay a higher price for these differentiated goods in which increases consumer surplus and limits the extent in which allocative inefficiency reduces social welfare.

Firms cannot afford to forego economies of scale to the same extent as monopolies and charge higher prices given that there are relatively good substitutes available to consumers, suggesting elastic demand.

May reinvest their normal profits to keep up with its competitors. (Prevalent within the clothing industry)