Monopolistic Competition Notes

Monopolistic Competition (LO12.1)

Monopolistic competition is a market structure characterized by:

1. A relatively large number of sellers.

2. Differentiated products, often promoted through advertising.

3. Easy entry to and exit from the industry.

The first and third characteristics provide the "competitive" aspect while the second provides the "monopolistic" aspect. Monopolistically competitive industries are generally more competitive than monopolistic.

Relatively Large Number of Sellers

Monopolistic competition involves a fairly large number of firms (e.g., 25, 35, or 70), but not as many as in pure competition. Key implications include:

• Small market shares: Each firm has a small percentage of the total market, limiting control over market price.

• No collusion: A large number of firms makes it unlikely for firms to collude to restrict output and set prices.

• Independent action: Firms can determine their pricing policies without considering rivals' reactions. A modest price cut by one firm has a negligible impact on competitors.

Differentiated Products

Unlike pure competition where products are standardized, monopolistic competition features product differentiation. Firms produce variations of a particular product with slight differences in:

• Physical characteristics

• Customer service

• Locational convenience

• Perceived qualities

Product Attributes

Product differentiation includes physical or qualitative differences in products, such as variations in functional features, materials, design, and workmanship.

• Examples: Personal computers differing in storage, speed, and graphic displays; retail stores selling clothes with different styling and quality; pizzerias offering thin-crust Neapolitan-style versus thick-crust Chicago-style pizza.

Service

Service and conditions surrounding a sale also differentiate products. Examples include:

• Shoe stores with knowledgeable clerks.

• Varying levels of customer service (e.g., self-service vs. full-service).

• Prestige appeal, reputation for service, exchange policies, and credit availability.

Location

Location and accessibility of stores differentiate products. Small convenience stores compete with large supermarkets based on location, despite higher prices. Motels near highways can charge higher rates due to convenient location.

Brand Names and Packaging

Brand names, trademarks, packaging, and celebrity endorsements also create product differentiation. Consumers may believe that brands like Bayer, Anacin, or Bufferin are superior to generic aspirin. Celebrity endorsements enhance appeal, and packaging (e.g., “natural spring” water) attracts customers.

Some Control over Price

Monopolistic competitors have some control over prices due to product differentiation. Consumers are willing to pay more for preferred products, but this control is limited by numerous potential substitutes.

Easy Entry and Exit

Entry into monopolistically competitive industries is relatively easy due to few economies of scale and low capital requirements. However, financial barriers may arise from the need to develop and advertise differentiated products. Trade secrets and trademarks can also make imitation costly.

Exit is relatively easy; firms can simply hold a going-out-of-business sale and shut down.

Advertising

Advertising is crucial for making consumers aware of product differences. It aims to make price less of a factor and product differences a greater factor in consumer purchases. Successful advertising shifts the firm's demand curve to the right and makes it steeper, reducing elasticity and increasing pricing power.

Advertising is a fixed cost, shifting Average Variable Cost (AVC) and Average Total Cost (ATC) curves upward. A firm advertises hoping for a sufficient rightward shift in demand to compensate for increased costs. If the increase in revenue covers advertising costs, the campaign is a success; otherwise, it is a failure.

Monopolistically Competitive Industries

Economists measure industry concentration to differentiate monopolistically competitive industries from oligopolies using the four-firm concentration ratio and the Herfindahl index.

Concentration Ratio

The four-firm concentration ratio is the percentage of output (sales) of the four largest firms in an industry relative to total industry sales.

Four-firm\ concentration\ ratio = \frac{Output\ of\ four\ largest\ firms}{Total\ output\ in\ the\ industry}

Low ratios indicate purely competitive industries, while high ratios indicate oligopolies or pure monopolies. Industries with ratios of 40% or more are generally considered oligopolies. Table 12.1 lists industries with low concentration ratios, suggesting monopolistic competition.

Concentration ratios must be used cautiously, as national figures may not reflect local market concentration.

Herfindahl Index

The Herfindahl index is the sum of the squared percentage market shares of all firms in the industry.

Herfindahl\ index = (%S1)^2 + (%S2)^2 + (%S3)^2 + … + (%Sn)^2

Where %S_i is the percentage market share of firm i, The index gives greater weight to larger firms. It approaches zero in purely competitive industries and reaches a maximum of 10,000 in a single-firm industry (complete monopoly power).

Lower Herfindahl indices suggest monopolistic competition rather than oligopoly.

Examples

Besides manufacturing, monopolistic competition is found in professional services (e.g., medical care, legal assistance) and retail establishments (e.g., grocery stores, gas stations, hair salons).

Price and Output in Monopolistic Competition (LO12.2)

Monopolistic competitors earn only a normal profit in the long run due to the ease of entry and exit.

The Firm's Demand Curve

The demand curve faced by a monopolistically competitive seller is highly, but not perfectly, elastic. This is because:

1. Many other firms produce close substitutes (more elastic than a pure monopolist).

2. Products are differentiated and not perfect substitutes (less elastic than a pure competitor).

Determinants of Price Elasticity

The price elasticity of demand depends on the number of rivals and the degree of product differentiation. More rivals and weaker differentiation lead to greater price elasticity, approaching pure competition.

The Short Run: Profit or Loss

In the short run, firms maximize profit or minimize loss where marginal revenue equals marginal cost (MR = MC). Economic profit is possible, but losses can also occur due to unfavorable demand or costs.

The Long Run: Only a Normal Profit

In the long run, firms enter profitable industries and leave unprofitable ones, resulting in only normal profits (breaking even). Cost curves include both explicit and implicit costs, including a normal profit.

Profits: Firms Enter

Short-run profits attract new firms, shifting the demand curve faced by typical firms to the left (falls), reducing economic profit. Entry continues until demand is tangent to the average total cost curve at the profit-maximizing output.

Losses: Firms Leave

Short-run losses cause firms to exit, shifting the demand curves of surviving firms to the right (rise), eliminating losses and yielding normal profits.

Complications

A normal profit outcome may not always occur due to:

• Product differentiation that is hard to duplicate, giving some firms lasting advantages and modest economic profits.

• Financial barriers to entry due to product differentiation, resulting in some monopoly power and small economic profits.

Monopolistic Competition and Efficiency (LO12.3)

Monopolistic competition is neither productively nor allocatively efficient in the long run.

Productive efficiency requires P = MC = minimum ATC. Allocative efficiency requires producing the right amount of output, with price equaling marginal cost $(P = MC)$$

Neither Productive nor Allocative Efficiency

In monopolistic competition, the profit-maximizing price exceeds the lowest average total cost, meaning productive efficiency is not achieved. Also, price exceeds marginal cost, causing an underallocation of resources. The deadweight loss is the area between the demand curve and MC curve, representing foregone benefits.

Excess Capacity

Monopolistic competition leads to excess capacity: underused plant and equipment because firms produce less than the minimum-ATC output. Industries are overpopulated with firms operating below optimal capacity.

Product Variety (LO12.4)

Product differentiation helps compensate for economic inefficiency by offering benefits such as increased Consumer Choices and product improvement.

Benefits of Product Variety

Product variety and improvement benefit society and may offset the cost of inefficiency. Consumers have diverse tastes and can choose from a wide range of types, styles, and brands. Successful product improvements by one firm lead rivals to imitate or improve, benefiting society.

Product Differentiation and Trade-offs

Product differentiation creates a trade-off between consumer choice and productive efficiency. Stronger differentiation leads to greater excess capacity and inefficiency, but also satisfies diverse tastes.

Further Complexity

Firms juggle price, product, and advertising to maximize profit. Each combination creates different demand and cost situations. The optimal combination is found by trial and error.