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Monopolistic competition

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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
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. 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).[1] Joan Robinson also receives credit as an early pioneer on the
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.[2]
• 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.

• 1 Major characteristics
• 2 Product differentiation
• 3 Many firms
• 4 Free entry and exit
• 5 Independent decision making
• 6 Market power
• 7 Perfect information
• 8 Inefficiency
• 9 Problems
• 10 Examples
• 11 Notes
• 12 See also
• 13 External links

[edit] 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[3][4]
[edit] 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.[5] MC
goods are best described as close but imperfect substitutes.[5] 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.
[edit] 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".[6] 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.[7]
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.
[edit] 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.
[edit] Independent decision making
Each MC firm independently sets the terms of exchange for its product.[8] The firm gives no
consideration to what effect its decision may have on competitors.[9] 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 hightened competition. In other words each firm feels free to set prices as if it
were a monopoly rather than an oligopoly.
[edit] 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.
Market power also means that an MC firm faces a downward sloping demand curve. The
demand curve is highly elastic although not "flat".
[edit] 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.[11]
Market Structure comparison
Numbe Marke Elasticit Product Profit
Excess Efficienc Pricing
r of t y of differentiatio maximizatio
profits y power
firms power demand n n condition
Perfectly P=MR=MC[1 Price
Competitio Infinite None None No Yes[12] 3]
elastic taker[13]
Monopolisti Yes/No
elastic Price
c Many Low High[15] (Short/Lon No[17] MR=MC[13]
(long setter[13]
competition g) [16]
Relativel Absolute
Monopoly One High y (across Yes No MR=MC[13]
inelastic industries)

[edit] 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.[18]
[edit] Problems
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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.[citation needed]
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.[19]
[edit] 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
[edit] Notes
1. ^ Monopolistic Competition. Encyclopedia Britannica.
2. ^ Joshua Gans, Stephen King, Robin Stonecash, N. Gregory Mankiw (2003). Principles
of Economics. Thomson Learning. ISBN 0-17-011441-4.
3. ^ Goodwin, N, Nelson, J; Ackerman, F & Weissskopf, T: Microeconomics in Context 2d
ed. page 317 Sharpe 2009
4. ^ Hirschey, M, Managerial Economics Rev. Ed, page 443. Dryden 2000.
5. ^ a b Krugman & Wells: Microeconomics 2d ed. Worth 2009.
6. ^ Samuelson, W & Marks, S: 379. Managerial Economics 4th ed. Wiley 2003.
7. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 485. Pearson
8. ^ Colander, David C. Microeconomics 7th ed. Page 283. McGraw-Hill 2008.
9. ^ Colander, David C. Microeconomics 7th ed. Page 283. McGraw-Hill 2008.
10. ^ Perloff, J: Microeconomics Theory & Applications with Calculus page 483 Pearson
11. ^ Goodwin, N, Nelson, J; Ackerman, F & Weissskopf, T: Microeconomics in Context 2d
ed. page 289. Sharpe 2009
12. ^ Ayers, R & Collinge, R: Microeconomics pages 224-25 Pearson 2003
13. ^ a b c d e f Perloff, J: Microeconomics Theory & Applications with Calculus page 445.
Pearson 2008.
14. ^ Ayers, R & Collinge, R: Microeconomics page 280 Pearson 2003
15. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 424 Prentice-Hall 2001.
16. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 425 Prentice-Hall 2001.
17. ^ Pindyck, R & Rubinfeld, D: Microeconomics 5th ed. page 427 Prentice-Hall 2001.
18. ^ The firm has not reached full capacity or minimum efficient scale. Minimum efficient
scale is the level of production at which the long run average cost curve first reaches its
minimum. It is the point where the LRATC curve "begins to bottom out." Perloff, J:
Microeconomics Theory & Applications with Calculus pages 483-84. Pearson 2008.
19. ^ Antony Davies & Thomas Cline (2005). "A Consumer Behavior Approach to Modeling
Monopolistic Competition". Journal of Economic Psychology 26: 797–826.
[edit] See also
• Atomistic market
• Imperfect competition
• Microeconomics
• Monopolistic competition in international trade
• Perfect competition
• Simulations and games in economics education
[edit] External links
• Monopolistic Competition by Elmer G. Wiens
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Categories: Imperfect competition | Market structure and pricing
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