Monopolistic Competition

Monopolistic competition

Monopolistic competition is a form of imperfect competition where many competing producers sell products that are differentiated from one another (that is, the products are substitutes, but, with differences such as branding, are not exactly alike). In monopolistic competition firms can behave like monopolies in the short-run, including using market power to generate profit. In the long-run, other firms enter the market and the benefits of differentiation decrease with competition; the market becomes more like perfect competition where firms cannot gain economic profit. However, in reality, if consumer rationality/innovativeness is low and heuristics is preferred, monopolistic competition can fall into natural monopoly, at the complete absence of government intervention.[1] At the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition was Edward Hastings Chamberlin in his pioneering book on the subject Theory of Monopolistic Competition (1933).[2] Joan Robinson also receives credit as an early pioneer on the concept.

Monopolistically competitive markets have the following characteristics: * There are many producers and many consumers in a given market, and no business has total control over the market price. * Consumers perceive that there are non-price differences among the competitors' products. * There are few barriers to entry and exit.[3] * Producers have a degree of control over price.
The long-run characteristics of a monopolistically competitive market are almost the same as in perfect competition, with the exception of monopolistic competition having heterogeneous products, and that monopolistic competition involves a great deal of non-price competition (based on subtle product differentiation). A firm making profits in the short run will break even in the long run because demand will decrease and average total cost will increase. This means in the long run, a monopolistically competitive firm will make zero economic profit. This gives the amount of influence over the market; because of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm's demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The difference between the firms average revenue and average cost gives it a profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit

Major characteristics
There are six characteristics of monopolistic competition (MC): * product differentiation * many firms * free entry and exit in long run * Independent decision making * Market Power * Buyers and Sellers have perfect information[4][5]

Product differentiation
MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as to eliminate goods as substitutes. Technically the cross price elasticity of demand between goods would be positive.In fact the XED would be high.[6] MC goods are best described as close but imperfect substitutes.[6] The goods perform the same basic functions. The differences are in "qualities" and circumstances such as type, style, quality, reputation, appearance, and location that tend to distinguish goods. For example, the function of motor vehilces is basically the same - to get from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles, motor scooters, motor cycles, trucks, cars and SUVs.

Many firms
There are many firms in each MC product group and many firms on the side lines prepared to enter the market. A product group is a "collection of similar products".[7] The fact that there are "many firms" gives each MC firm the freedom to set prices without engaging in strategic decision making.The requirements assures that each firm's actions have a negligible impact on the market. For example. a firm could cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors.

How many firms will an MC market structure support at market equilibrium? The answer depends on factors such as fixed costs, economies of scale and the degree of product differentiation. For example, the higher the fixed costs the fewer firms the market will support.[8] Also the greater the degree of product differentiation - the more the firm can separate itself from the pack - the fewer firms there will be in market equilibrium.

Free entry and exit
In the long run there is free entry and exit. There are numerous firms awaiting to enter the market each with its own "unique" product or in pursuit of positive profits and any firm unable to cover its costs can leave the market without incurring liquidation costs. This assumption implies that there are low start up costs, no sunk costs and no exit costs.

Independent decision making
Each MC firm independently sets the terms of exchange for its product.[9] The firm gives no consideration to what effect its decision may have on competitors.[10] The theory is that any action will have such a negligible effect on the overall market demand that an MC firm can act without fear of prompting heightened competition. In other words each firm feels free to set prices as if it were a monopoly rather than an oligopoly.

Market power
MC firms have some degree of market power. Market power means that the firm has control over the terms and conditions of exchange. An MC firm can raise it prices without losing all its customers. The firm can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC firm's market power is not barriers to entry since there are none. An MC firm derives it's market power from the fact that it has relatively few competitors, competitors do not engage in strategic decision making and the firms sells differentiated product.[11] Market power also means that an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although not "flat".

Perfect information
Buyers know exactly what goods are being offered, where the goods are being sold, all differentiating characteristics of the goods, the good's price, whether a firm is making a profit and if so how much.

Market Structure comparison | | Number of firms | Market power | Elasticity of demand | Product differentiation | Excess profits | Efficiency | Profit maximization condition | Pricing power | Perfect Competition | Infinite | None | Perfectly elastic | None | No | Yes[13] | P=MR=MC[14] | Price taker[14] | Monopolistic competition | Many | Low | Highly elastic (long run)[15] | High[16] | Yes/No (Short/Long) [17] | No[18] | MR=MC[14] | Price setter[14] | Monopoly | One | High | Relatively inelastic | Absolute (across industries) | Yes | No | MR=MC[14] | Price setter[14] |

Inefficiency
There are two sources of inefficiency in the MC market structure. First, at its optimum output the firm charges a price that exceeds marginal costs, The MC firm maximizes profits where MR = MC. Since the MC firm's demand curve is downward sloping this means that the firm will be charging a price that exceeds marginal costs. The monopoly power possessed by an MC firm means that at its profit maximizing level of production there will be a net loss of consumer (and producer) surplus. The second source of inefficiency is the fact that MC firms operate with excess capacity. That is, the MC firm's profit maximizing output is less than the output associated with minimum average cost. Both a PC and MC firm will operate at a point where demand or price equals average cost. For a PC firm this equilibrium condition occurs where the perfectly elastic demand curve equals minimum average cost. An MC firm’s demand curve is not flat but is downward sloping. Thus in the long run the demand curve will be tangent to the long run average cost curve at a point to the left of its minimum. The result is excess capacity.[19]

Problems Economics | | Economies by region Africa · North America
South America · Asia
Europe · Oceania | | | | | | | | | | | | |

While monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits; the government would have to regulate all firms that sold heterogeneous products—an impossible proposition in a market economy. A monopolistically competitive firm might be said to be marginally inefficient because the firm produces at an output where average total cost is not a minimum. A monopolistically competitive market might be said to be a marginally inefficient market structure because marginal cost is less than price in the long run.

Another concern of critics of monopolistic competition is that it fosters advertising and the creation of brand names. Critics argue that advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. This is disputed by defenders of advertising who argue that (1) brand names can represent a guarantee of quality, and (2) advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands. There are unique information and information processing costs associated with selecting a brand in a monopolistically competitive environment. In a monopoly industry, the consumer is faced with a single brand and so information gathering is relatively inexpensive. In a perfectly competitive industry, the consumer is faced with many brands. However, because the brands are virtually identical, again information gathering is relatively inexpensive. Faced with a monopolistically competitive industry, to select the best out of many brands the consumer must collect and process information on a large number of different brands. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand (versus a randomly selected brand).

Evidence suggests that consumers use information obtained from advertising not only to assess the single brand advertised, but also to infer the possible existence of brands that the consumer has, heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised brand.[20]

Examples
In many U.S. markets, producers practice product differentiation by altering the physical composition, using special packaging, or simply claiming to have superior products based on brand images and/or advertising. Toothpastes and toilet papers are examples of differentiated products.

Monopolistic competition in international trade
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Monopolistic competition models are used under the rubric of imperfect competition in International Economics. This model is a derivative of the monopolistic competition model that is part of basic economics. Here it is tailored to international trade. Contents[hide] * 1 Setting up the model * 2 Benefits of the model * 3 Assumptions of the model * 3.1 Background of the Model * 4 Notes |
[edit] Setting up the model
Monopolies are not often found in practice, the more usual market format is oligopoly: several firms, each of whom is big enough that a change in their price will affect the price of the other firms, but none with an unchallenged monopoly. When looking at oligopolies the problem of interdependence arises. Interdependence means that the firms will, when setting their prices, consider the effect this price will have on the actions of both consumers and competitors. For their part, the competitors will consider their expectations of the firm's response to any action they may take in return. Thus, there is a complex game with each side "trying to second guess each others' strategies."[1] The Monopolistic Competition model is used because its simplicity allows the examination of one type of oligopoly while avoiding the issue of interdependence.
[edit] Benefits of the model
The appeal of this model is not its closeness to the real world but its simplicity. What this model accomplishes most is that it shows us the benefits to trade presented by economies of scale.
[edit] Assumptions of the model * 1. Each firm is presumed to be able differentiate its product from that of its rivals. Cars are a good example here; they are very different, yet in direct competition with each other. This means there will be some customer loyalty, which allows for some flexibility for the firm to move to a higher price. In other words, not all of a firm's customers would leave for other products if the firm raised its prices. * 2. This model dismisses the issue of interdependence when a firm sets its price. The firm will act as if it were a monopoly regarding the price it sets, not considering the potential responses from its competitors. The justification is that there are numerous firms in the market, so each receives only scant attention from the others.
[edit] Background of the Model * An industry consisting of a number of firms, each of which produces differentiated products. The firms are monopolists for their products, but depend somewhat of the number of reasonable alternatives available and the price of those alternatives. Each firm within the industry thus faces a demand that is effected by the price and prevalence of reasonable alternatives. * Generally we expect a firm's sales to increase the stronger the total demand for the industry's product as a whole. Conversely, we expect the firm to sell less if there are a significant number of firms in the industry and/or the higher the firm's price in relation to those competitors. The demand equation for such a firm would be:
Q = S x [1/n - b x (P - P)] * "Q" = the firm's sales. "S" is the total sales of the industry. "n" is the number of firms in the industry, "b" is a constant term representing the responsiveness of a firm's sales to its price. "P" is the price charged by the firm itself. "P" is the average price charged by its competitors. * The intuition of this model is: * If all firms charge the same price their respective market share will be 1/n. Firms charging more get less, firms charging less get more. * (Note) Assume that lower prices will not bring new consumers into the market. In this model consumers can only be gained at the expense of other firms. This simplifies things, allowing a focus on the competition among firms and also allows the assumption that if S represents the market size, and the firms are charging the same price, the market share of each firm will be S/n.

Teach Examples of Monopolistic Competition using an Economic Simulation Game There is an extensive and growing literature on the pedagogical effectiveness of simulation games in education (see Lean, Moizer, and Towler, 2006; Simkins, 1999; Motahar, 1994). The purpose of this note is to explain and illustrate how an economics simulation game can be used as an example and application of the monopolistic competition market to help in the teaching and learning of this market. A comprehensive guide on how to incorporate simulation games in business education at the college level is given by Gentry, et. Al. (1990).Use in Standard Classroom or for Experimental Economics A monopolistic competition simulation can be used as an example in the standard economics classroom or for experimental economics. Economic experiments using monopolistic competition simulations can create real-world incentives that may be used in the teaching and learning of economics to help students better understand why markets and other exchange systems work the way they do. A detailed explanation of experimental economics is given by Roth (1995). An online computerized economic simulation game called “Beat the Market” is used to simulate several different examples of the monopolistic competition market (see a brief description of the simulation game at the AEA website. This simulation is designed to put students inside the theoretical world of monopolistic competition as described in the standard economics textbook. Through the simulation, students participate directly in the market by managing a simulated firm and making decisions on price and production to maximize profits. Assumptions of Monopolistic Competition Simulation Game Example All the example simulations follow the basic theoretical assumptions of the monopolistic competition market structure and include: 1. A large number of firms, at least 25. 2. Small firm size, starting market share of each firm about 4%. 3. Easy entry and exit, based on economic versus normal profits. 4. Product differentiation is possible but limited.Options in Simulating the Monopolistic Competition Market In the example simulations, the instructor may select different environments within the context of monopolistic competition, including: 1. Short-run versus long-run 2. Degree of product differentiation 3. Macroeconomic environment (stable, growth, cyclical)Two simulation game examples will be illustrated, including one short-run and one long-run simulation. The example simulations illustrated here will hold the degree of product differentiation and the macroeconomic environment constant. (But the software does allow these variables, options 2 and 3 above, to be included at the discretion of the instructor.)Short-run Monopolistic Competition Game Example Simulation The short-run simulations do not allow students to change the plant size of their firm, but firms will still enter or exit the market if accounting profits differ from normal profit levels in the simulated monopolistic competition market. Controllable Decisions in the Short-run Monopolistic Competition Simulation Game Example a. Firm Price b. Firm ProductionSimulation Performance in Short-run Example At the start, the market is not in equilibrium and has the following characteristics. Quarter | Number of Firms | Market Price | Market Demand | Market Supply | Average Accounting Profit | 0 | 25 | $75.11 | 127,125 | 102,500 | $119,522 |
Note that normal profits in this market are $100,000 and the average market profit is $119,522. Students make decisions for their firms based on their own firm characteristics. In this market example, firms start with an excess demand. Students are given information on their firm costs and revenues, including marginal costs and marginal revenues. The knowledgeable students (and the numerous computer managed firms) begin by raising their prices and increasing the quantity supplied. No matter the decisions of any student managed firm, the overall behavior of the market is not influenced by any one student, since each firm is very small in size relative to the market. In quarter 1 in this example, average firm accounting profits increase, but through time the following expected results occur. Short-run Simulation Results (Normal Profits $100,000) Quarter | Number of Firms | Market Price | Market Demand | Market Supply | Average Accounting Profit | 1 | 25 | $78.56 | 110,480 | 110,400 | $137,846 | 2 | 27 | $76.96 | 118,271 | 118,508 | $131,218 | 3 | 30 | $74.71 | 129,167 | 131,224 | $119,487 | 4 | 32 | $73.02 | 137,328 | 139,484 | $112,033 | 5 | 35 | $70.89 | 147,551 | 150,227 | $102,998 | 6 | 35 | $70.04 | 151,632 | 152,417 | $100,573 |
After quarter 1, new firms entered the market because accounting profits exceeded normal profit levels of $100,000 in this example. The number of firms increased from 25 in quarter 1 to 35 in quarter 5. No additional firms entered in quarter 6 because accounting profits were close to normal levels. The decrease in accounting profits occurred because the market price declined as new firms entered and the markets supply increased. The market stabilized after six quarters because economic profits were at, or close to, zero; and market demand was close to market supply.Long-run Monopolistic Competititon Simulation Example The long-run simulation example allows students to change the plant size of their firm and take advantage of economies of scale. Both economies and diseconomies of scale exist in the simulation. Students are given information on how the average variable costs change in the simulation with increases in plant size. But again, as required in the model, firms will enter or exit the monopolistic competition market until economic profits return to zero. Controllable Student Decisions in Long-run Simulation ExampleIn this example, plant size is added as a third controllable student decision, and now includes: a. Firm price b. Firm production c. Firm plant size Simulation Performance in Long-run Example At the start, the market is not in equilibrium and has the following characteristics. Quarter | Number of Firms | Average Plant Size | Market Price | Market Demand | Market Supply | Average Accounting Profit | 0 | 25 | 6.0 | $75.11 | 127,125 | 102,500 | $119,522 |
Note that the starting characteristics of the market are set to be the same as in the short-run example. Normal profits are again $100,000. In this way comparisons can be made more directly between the two simulation examples. The major difference in the long-run example is that plant size may now be changed. As in the previous simulation example, all firms start with an excess demand, and their accounting profits are initially $119, 522, which are greater than normal profits. Given this starting scenario, students again begin by raising their prices and increasing the quantity supplied. But this time, plant size also increases as students take advantage of economies of scale that is built into this simulation example. Firm profits increase initially, but through time the following expected results occur.Long-run Simulation Results (Normal Profits $100,000) Quarter | Number of Firms | Average Plant Size | Market Price | Market Demand | Market Supply | Average Accounting Profit | 1 | 25 | 6.0 | $78.64 | 111,621 | 110,347 | $137,243 | 2 | 27 | 7.4 | $75.01 | 130,283 | 129,595 | $141,475 | 3 | 30 | 9.0 | $69.75 | 156,602 | 157,854 | $133,859 | 4 | 33 | 10.7 | $63.86 | 185,217 | 192,432 | $117,176 | 5 | 36 | 11.4 | $58.98 | 208,652 | 220,541 | $ 98,669 | 6 | 36 | 11.6 | $56.86 | 219,731 | 221,730 | $ 99,870 |
These results had a number of similarities to the short-run example, but also some major differences. As in the short-run example, firms entered the market after quarter 1 because accounting profits exceeded normal profit levels of $100,000. The number of firms increased and the market stabilized after six quarters because economic profits were at, or close to, zero; and market demand was close to market supply.

But in the long-run simulation example there were several important differences. 1. Plant size increased significantly since it was a controllable decision of the firm and there were economies of scale. 2. Economies of scale meant firms were able to take advantage of lower average costs and initially earn higher profits (before entry of new firms). 3. Market price was bid down much lower than in the short-run example because firms were able to lower their average costs of production, and firms continued to enter the market as long as economic profits existed. 4. Even though firms were able to reduce costs through economies of scale, they were not able to maintain profits above normal levels in the long-run. Concluding Remarks

From an educational point of view, the benefit of a simulation game example is that students will have an “opportunity” to learn by their own observations and experience. In these simulation examples, student participants would observe and experience that their pricing decisions are controlled by the market. They would “experience” that in the simulation they would have to lower their firm’s price to be competitive as new firms entered the market. In the long-run simulation example, they would see the impact of changing plant size. They would observe that the successful firms would take advantage of economies of scale, but would also be careful not to incur diseconomies of scale in the long-run. Students would see the benefits of economies of scale in reducing costs and increasing profits, but experience that economic profits cannot be maintained in the long-run. They would observe, first hand, that their accounting profits will inevitably decline and move closer to normal profits. While participating in the simulation, students would experience the same dilemmas and frustrations that firm owners face in the real world. This experience provides students another opportunity to learn (as a supplement to the lecture and readings) the economic messages of monopolistic competition. |

Monopolistic Competition
Let us continue with our example of the pushcarts, but let us change assumptions. Let the beach be very, very long, and let buyers face a cost in getting to and from the seller. To make this second assumption specific, assume that it costs buyers $1.00 to travel a mile. Finally, assume that there is one seller on the beach and that everyone values the product he sells at $10.00.
If the seller prices his product at $6.00, how many people will buy it? He should get all those people who are located less than two miles from him. To see this answer, consider someone located one mile away. This person finds that the product costs $8.00 to get because she must pay $6.00 and travel two miles (one going and one returning). Because $8.00 is less than the benefits of $10.00 she gets from the product, she will buy. If she was located three miles away, the product would now cost her $12.00 ($6.00 to the seller and $6.00 of transport costs), so she would not buy.
Now, suppose that another seller decides to locate on our very long beach. Unlike the Hotelling beach, he will not locate next to the original seller. The assumptions of transport costs and long beach change this result. In fact, the new seller should move down the beach until he has his own four-mile stretch of beach.
Suppose that both sellers are doing a great business and getting rich. Because it is very easy to roll another push cart onto the beach, the unusually high returns in this business should attract new sellers. Suppose that a new seller locates exactly two miles away from our first seller. How much of the beach will each control? If they both charge the same price, then they will evenly split the beach between them, or each will attract customers within one mile.
However, to make the story a bit more complicated, suppose that the new seller raises his price to $7.00. If the original seller still charges $6.00, then the dividing line separating customers between them will be 1.25 miles from the original seller and .75 miles from the higher-priced seller. (If you check the cost of the buyer at this point, you should see that it costs her $8.50 to go to either seller.)
In the previous example each seller has some control over price. Each realizes that if he charges a higher price, he loses some customers, but not all of them. In this way, the sellers are like monopolies: They are price searchers facing downward-sloping demand curves. However, they also are in an industry that has easy entry and exit, and as a result, there will be no long-term profits (as economists define profits) and in this way resemble price takers in perfect competition, the sellers we discussed when we drew supply curves. Because it has both elements of monopoly and competition, economists classify an industry of this type as monopolistic competition.
The model of monopolistic competition puts our situation into a more familiar form of demand and cost curves. The illustration below shows a seller with a downward-sloping demand curve and a conventional marginal cost curve. Because the demand curve slopes downward, the marginal revenue curve lies below it. The seller maximizes profit by selecting that output at which marginal revenue equals marginal costs and charges as much as he can, which is price P2. In the long run, there can be no economic profit because there is free entry into the industry. If there are any profits, others will enter the industry, positioning themselves to take away customers from the most profitable sellers. The zero profit condition implies that at equilibrium, average revenue (which is demand) must just equal average cost. When average revenue equals average cost, average profit is zero, and so total profit must also be zero.

The model of monopolistic competition was considered important when it was introduced for two reasons. First, the situation it described seemed the most common form of industry. Both the single sellers of monopoly and the many sellers of price-taking competition are uncommon in comparison. Furthermore, monopolistic competition describes more than traveling costs in a geographical sense. The distance between sellers can be in the minds of buyers. Product differentiation, which results in many products that are similar but not identical, also creates a distance between products. It was this distance that seemed especially important to the developers of monopolistic competition.1
Second, notice that because price exceeds marginal cost, the graph contains a gray area of welfare loss, an unexploited value that neither firms nor customers obtain. Because monopolistic competition was seen as both common and economically inefficient, it was argued that market systems were inherently inefficient.
However, the welfare loss in the case of monopolistic competition may be illusionary. Firms could obtain this value if they could price discriminate, selling beyond q* up to qo. If they do not do so, then the resources needed to obtain the information required to price in this fashion must be more valuable than the triangle of unexploited value. Or consider possible government solutions. The problem is that sellers are too small and charge too high a price. The government could react by limiting the number of sellers and forcing them to charge lower prices. But this policy would increase traveling costs of buyers. The market may not give the optimal number of sellers (and hence the optimal distance between them), but the cost of gathering the information that would let government decide the matter is almost certainly greater than any possible welfare gain (even ignoring the political incentives that always go with government solutions).
Some economists have argued that the distance between products is often phony, that firms differentiate products to fool consumers. Their argument is surely correct in many cases. In other cases, however, product differentiation exists because it reflects differences in people's tastes. Again, there is a cost to deciding whether in each case product differentiation manipulates buyers or caters to them. It is not clear that any government policy that tries to eliminate "bad" differentiation will have benefits that exceed its costs.
When the cost of correcting a problem exceeds the possible gain from the correction, is there any real welfare loss by allowing the problem to continue? The model of monopolistic competition shows that real market systems fall short of theoretical constructs that assume away the problems of information and of making agreements among people. But any real-world system looks bad compared to theory that assumes away problems.
Finally, the theory developed above does have at least one interesting use in explaining the real world. When traveling costs are reduced, people become more price-sensitive, which means that the demand curve facing each seller gets more elastic. As a result, the marginal revenue curve shifts upward and will intersect the marginal cost curve at a higher quantity (or greater distance). For individual firms to expand sales when the industry sales are constant requires some firms to disappear. Reducing traveling costs reduces the number of firms, and development of the automobile and the highway system drastically cut traveling costs in the United States. As a result, throughout America there are thousands of villages that have completely or largely lost their retail districts.

Advantages and Disadvantages of Monopolistic Competition

Advantage is the ability to plan long term as there are no market surprises. The monopoly can also invest more money in a single direction as it does not have to worry about a competitor attacking it from another angle or technology. Finally, some industries are natual monopolies. You would not have competing water companies.

The disadvantage of a monopoly is that there is nothing forcing the monopoly to make any investments, hold down fees, or provide good service.