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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 firm's average revenue and
average cost, multiplied by the quantity sold (Qs), gives the total 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
Economics
A supply and demand diagram, illustrating
the effects of an increase in demand.
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Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another (e.g. by branding or quality) and hence are not
perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given
and ignores the impact of its own prices on the prices of other firms.[1][2] In 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 is Edward Hastings Chamberlin, who
wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933).[3] Joan
Robinson published a book The Economics of Imperfect Competition with a comparable theme of
distinguishing perfect from imperfect competition.
Monopolistically competitive markets have the following characteristics:
There are many producers and many consumers in the market, and no business has total
control over the market price.
Consumers perceive that there are non-price differences among the competitors' products.
Contents
[hide]
Product differentiation
Many firms
Freedom of Entry and Exit
Independent decision making
Some degree of market power
Buyers and sellers do not have perfect information (Imperfect Information)[5][6]
Product Differentiation[edit]
MC firms sell products that have real or perceived non-price differences. However, the differences
are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of
demand between goods in such a market is positive. In fact, the XED would be high.[7] MC goods are
best described as close but imperfect substitutes.[7] The goods perform the same basic functions but
have differences in qualities such as type, style, quality, reputation, appearance, and location that
tend to distinguish them from each other. For example, the basic function of motor vehicles is the
same—to move people and objects from point to point in reasonable comfort and safety. Yet there
are many different types of motor vehicles such as motor scooters, motor cycles, trucks and cars,
and many variations even within these categories.
Many firms[edit]
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".[8] The fact that there are "many
firms" gives each MC firm the freedom to set prices without engaging in strategic decision making
regarding the prices of other firms and 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.[9]
Freedom of Entry and Exit[edit]
Like perfect competition, under monopolistic competition also, the firms can enter or exit freely. The
firms will enter when the existing firms are making super-normal profits. With the entry of new firms,
the supply would increase which would reduce the price and hence the existing firms will be left only
with normal profits. Similarly, if the existing firms are sustaining losses, some of the marginal firms
will exit. It will reduce the supply due to which price would rise and the existing firms will be left only
with normal profit.
Independent decision making[edit]
Each MC firm independently sets the terms of exchange for its product.[10] 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[edit]
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 its 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 they are low. Rather, an MC firm
has market power because it has relatively few competitors, those 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".
Imperfect information[edit]
No sellers or buyers have complete market information, like market demand or market supply.[12]
Profit
Numb Mark Elasticit Product Pricin
Excess Efficien maximizati
er of et y of differentiati g
profits cy on
firms power demand on power
condition
Perfect Price
Perfectl P=MR=MC[
Competitio Infinite None None No Yes[13] 14] taker[14
y elastic ]
n
Monopolist Highly
ic elastic Yes/No Price
Many Low High[16] (Short/Long) No[18] MR=MC[14] setter[1
competitio (long [17] 4]
n run)[15]
Relative Absolute Price
Monopoly One High ly (across Yes No MR=MC[14] setter[1
4]
inelastic industries)
Inefficiency[edit]
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 marginal
revenue = marginal cost. 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 a 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. A MC firm’s demand curve is not flat but is downward sloping.
Thus in the long run the demand curve will be tangential to the long run average cost curve at a
point to the left of its minimum. The result is excess capacity.[19]
Socially undesirable aspects compared to perfect competition [edit]
Selling costs: Products under monopolistic competition are spending huge amounts on
advertising and publicity. Much of this expenditure is wasteful from the social point of view. The
producer can reduce the price of the product instead of spending on publicity.
Excess Capacity: Under Imperfect competition, the installed capacity of every firm is large, but
not fully utilized. Total output is, therefore, less than the output which is socially desirable. Since
production capacity is not fully utilized, the resources lie idle. Therefore, the production under
monopolistic competition is below the full capacity level.
Unemployment: Idle capacity under monopolistic competition expenditure leads to
unemployment. In particular, unemployment of workers leads to poverty and misery in the
society. If idle capacity is fully used, the problem of unemployment can be solved to some
extent.
Cross Transport: Under monopolistic competition expenditure is incurred on cross
transportation. If the goods are sold locally, wasteful expenditure on cross transport could be
avoided.
Lack of Specialization: Under monopolistic competition, there is little scope for specialization or
standardization. Product differentiation practiced under this competition leads to wasteful
expenditure. It is argued that instead of producing too many similar products, only a few
standardized products may be produced. This would ensure better allocation of resources and
would promote economic welfare of the society.
Inefficiency: Under perfect competition, an inefficient firm is thrown out of the industry. But under
monopolistic competition inefficient firms continue to survive.
Problems[edit]
Monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating
prices for products sold in monopolistic competition exceed the benefits of such regulation.[citation needed] .
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 is productively inefficient market structure because marginal cost is less than price in the
long run. Monopolistically competitive markets are also allocatively inefficient, as the price given is
higher than Marginal cost. Product differentiation increases total utility by better meeting people's
wants than homogenous products in a perfectly competitive market.[citation needed]
Another concern is that monopolistic competition fosters advertising and the creation of brand
names. Advertising induces customers into spending more on products because of the name
associated with them rather than because of rational factors. Defenders of advertising dispute this,
arguing that brand names can represent a guarantee of quality and that 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 market, the consumer is faced with a single brand, making
information gathering relatively inexpensive. In a perfectly competitive industry, the consumer is
faced with many brands, but because the brands are virtually identical information gathering is also
relatively inexpensive. In a monopolistically competitive market, the consumer must collect and
process information on a large number of different brands to be able to select the best of them. In
many cases, the cost of gathering information necessary to selecting the best brand can exceed the
benefit of consuming the best brand instead of a randomly selected brand. The result is that the
consumer is confused. Some brands gain prestige value and can extract an additional price for that.
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[edit]
In many markets, such as toothpaste, soap, air conditioning, smartphones and toilet paper,
producers practice product differentiation by altering the physical composition of products, using
special packaging, or simply claiming to have superior products based on brand
images or advertising.[citation needed]
See also[edit]
Economics portal
Atomistic market
Government-granted monopoly
Imperfect competition
Microeconomics
Monopolistic competition in international trade
Monopoly
Natural monopoly
Oligopoly
Perfect competition
Notes[edit]
1. Jump up^ Krugman, Paul; Obstfeld, Maurice (2008). International Economics: Theory and Policy.
Addison-Wesley. ISBN 0-321-55398-5.
2. Jump up^ Poiesz, Theo B. C. (2004). "The Free Market Illusion Psychological Limitations of
Consumer Choice" (PDF). Tijdschrift voor Economie en Management. 49(2): 309–338.
3. Jump up^ "Monopolistic Competition". Encyclopædia Britannica.
4. Jump up^ Gans, Joshua; King, Stephen; Stonecash, Robin; Mankiw, N. Gregory (2003). Principles of
Economics. Thomson Learning. ISBN 0-17-011441-4.
5. Jump up^ Goodwin, N.; Nelson, J.; Ackerman, F.; Weisskopf, T. (2009). Microeconomics in
Context (2nd ed.). Sharpe. p. 317. ISBN 978-0-7656-2301-0.
6. Jump up^ Hirschey, M. (2000). Managerial Economics (Rev. ed.). Fort Worth: Dryden.
p. 443. ISBN 0-03-025649-6.
7. ^ Jump up to:a b Krugman; Wells (2009). Microeconomics (2nd ed.). New York: Worth. ISBN 978-0-
7167-7159-3.
8. Jump up^ Samuelson, W.; Marks, S. (2003). Managerial Economics (4th ed.). Wiley. p. 379. ISBN 0-
470-00044-9.
9. Jump up^ Perloff, J. (2008). Microeconomics Theory & Applications with Calculus. Boston: Pearson.
p. 485. ISBN 978-0-321-27794-7.
10. ^ Jump up to:a b Colander, David C. (2008). Microeconomics (7th ed.). New York: McGraw-Hill/Irwin.
p. 283. ISBN 978-0-07-334365-5.
11. Jump up^ Perloff, J. (2008). Microeconomics Theory & Applications with Calculus. Boston: Pearson.
p. 483. ISBN 978-0-321-27794-7.
12. Jump up^ Goodwin, N.; Nelson, J.; Ackerman, F.; Weisskopf, T. (2009). Microeconomics in
Context (2nd ed.). Sharpe. p. 289. ISBN 978-0-7656-2301-0.
13. Jump up^ Ayers, R.; Collinge, R. (2003). Microeconomics: Explore & Apply. Pearson. pp. 224–
225. ISBN 0-13-177714-9.
14. ^ Jump up to:a b c d e f Perloff, J. (2008). Microeconomics Theory & Applications with Calculus. Boston:
Pearson. p. 445. ISBN 978-0-321-27794-7.
15. Jump up^ Ayers, R.; Collinge, R. (2003). Microeconomics: Explore & Apply. Pearson. p. 280. ISBN 0-
13-177714-9.
16. Jump up^ Pindyck, R.; Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall.
p. 424. ISBN 0-13-030472-7.
17. Jump up^ Pindyck, R.; Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall.
p. 425. ISBN 0-13-030472-7.
18. Jump up^ Pindyck, R.; Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall.
p. 427. ISBN 0-13-030472-7.
19. Jump up^ 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. (2008). Microeconomics Theory &
Applications with Calculus. Boston: Pearson. pp. 483–484. ISBN 978-0-321-27794-7.
20. Jump up^ Antony Davies & Thomas Cline (2005). "A Consumer Behavior Approach to Modeling
Monopolistic Competition". Journal of Economic Psychology. 26 (6): 797–
826. doi:10.1016/j.joep.2005.05.003.
External links
Many firms.
Freedom of entry and exit.
Firms produce differentiated products.
Firms have price inelastic demand; they are price makers because the good is highly
differentiated
Firms make normal profits in the long run but could make supernormal profits in the short term
Firms are allocatively and productively inefficient.
In
the short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to
supernormal profit
Allocative inefficient. The above diagrams show a price set above marginal cost
Productive inefficiency. The above diagram shows a firm not producing on the lowest point of
AC curve
Dynamic efficiency. This is possible as firms have profit to invest in research and development.
X-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide
better products.
In monopolistic competition there are no barriers to entry. Therefore in long run, the
market will be competitive, with firms making normal profit.
How many soap powders are there? About 35. But, most of these brands are owned by
two companies, Unilever and Proctor and Gamble. Having brand proliferation means it
is harder for a new firm to enter the market. This is because a new firm would have to
compete against 30 established brands as opposed to 2. There is less chance of getting
a good market share with so many brands. Therefore the new firm would have an
incentive to keep different brands to deter competitors.
However, if you have merge different brands there may be economies of scale. You can
devote more resources and investment to improving that particular product and
maximising its efficiency. This might be appropriate for an industry like computer
software or computers. There used to be many different brands of computers until the
pc came to dominate.
Are the different brands catering to different sectors of the market. If you take the
restaurant business, there is a big difference between Chinese and Indian. If 2
restaurants merge, they would be better off retaining distinct business. It would make no
sense to have a restaurant which offered a mixture of Chinese/Indian – consumers
would trust it less.
If you fear the arrival of a powerful company, it might be good to consolidate your
brands. For example, there are many small search engines, but they would be better off
combining forces to compete against the mighty Google.
When you walk into a sports store to buy running shoes, you will find a number of brands, like Nike,
Adidas, New Balance, ASICS, etc.
i. On one hand, the market for running shoes seems to be full of competition, with thousands of
competing brands and low barriers to entry.
ii. On the other hand, its market seems to be monopolistic, due to uniqueness of each shoe brand and
power to charge different price.
2. Barriers to Entry
There are no barriers to entry. It ensures that there are neither supernormal profits nor any
supernormal losses to a firm in the long run.
3. Number of Sellers
There are large numbers of firms selling closely related, but not homogeneous products. Each firm
acts independently and has a limited share of the market. So, an individual firm has limited control
over the market price.
4. Marketing
Products are differentiated and these differences are made known to the buyers through
advertisement and promotion. These costs constitute a substantial part of the total cost under
monopolistic competition.
5. Perfect Knowledge
There is imperfect knowledge in the market. People don’t know who is selling the good the cheapest
or who has the best quality. Sometimes a higher priced product is preferred even though it is of
inferior quality.
Even though there is allocative inefficiency (where Price exceeds Marginal Cost) in monopolistic
competition, there is a greater variety of products for the customer to select. However, costs rise
because firms are forced to spend money on advertising.
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Liquidity Preference Theory
Monopolistic Competition: Short-Run Profits and
Losses, and Long-Run Equilibrium
However, if the average total cost is above the market price, then
the firm will incur losses, equal to the average total cost minus the
market price multiplied by the quantity produced. It will still
minimize losses by producing that quantity where marginal
revenue equals marginal cost, but eventually the firm will either
have to reverse the losses, or it will have to exit the industry.
Short-Run Loss = (ATC - Price) × Quantity
However, if there are too many firms, then firms will incur losses,
especially the inefficient ones, which will cause them to leave the
industry. Consequently, the remaining firms will return to normal
profitability. Hence, the long-run equilibrium for monopolistic
competition will equate the market price to the average total cost,
where marginal revenue equals marginal cost, as shown in the
diagram below. Remember, in economics, average total cost
includes a normal profit.
Note that where MC rises above MR, the firm would incur greater costs than it would
receive in additional revenue, which is why the firm maximizes its profit by producing only
that quantity where MR = MC, and charging the price at 1.
2 Market Price = Marginal Cost = Allocative Efficiency
3 Productive Efficiency = Minimum ATC
Excess Capacity = Quantity Produced at Minimum ATC - Quantity that yields the
greatest profit (MR = MC).
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Learning Objectives
Differentiated Products
A firm can try to make its products different from those of its competitors
in several ways: physical aspects of the product, location from which the
product is sold, intangible aspects of the product, and perceptions of the
product. Products that are distinctive in one of these ways are
called differentiated products.
Physical aspects of a product include all the phrases you hear in
advertisements: unbreakable bottle, nonstick surface, freezer-to-
microwave, non-shrink, extra spicy, newly redesigned for your comfort. The
location of a firm can also create a difference between producers. For
example, a gas station located at a heavily traveled intersection can
probably sell more gas, because more cars drive by that corner. A supplier
to an automobile manufacturer may find that it is an advantage to locate
close to the car factory.
Intangible aspects can differentiate a product, too. Some intangible aspects
may be promises like a guarantee of satisfaction or money back, a
reputation for high quality, services like free delivery, or offering a loan to
purchase the product. Finally, product differentiation may occur in the
minds of buyers. For example, many people could not tell the difference in
taste between common varieties of beer or cigarettes if they were
blindfolded but, because of past habits and advertising, they have strong
preferences for certain brands. Advertising can play a role in shaping these
intangible preferences.
The concept of differentiated products is closely related to the degree of
variety that is available. If everyone in the economy wore only blue jeans,
ate only white bread, and drank only tap water, then the markets for
clothing, food, and drink would be much closer to perfectly competitive.
The variety of styles, flavors, locations, and characteristics creates product
differentiation and monopolistic competition.
Figure 2. How a Monopolistic Competitor Chooses its Profit Maximizing Output and Price. To
maximize profits, the Authentic Chinese Pizza shop would choose a quantity where marginal
revenue equals marginal cost, or Q where MR = MC. Here it would choose a quantity of 40 and a
price of $16.
intersection of the marginal revenue curve (MR ) and marginal cost curve
0
the demand curve at point T with price P . The combination of price P and
0 0
quantity Q lies above the average cost curve, which shows that the firm is
0
Figure 3. Monopolistic Competition, Entry, and Exit. (a) At P0 and Q0, the monopolistically
competitive firm shown in this figure is making a positive economic profit. This is clear because
if you follow the dotted line above Q0, you can see that price is above average cost. Positive
economic profits attract competing firms to the industry, driving the original firm’s demand
down to D1. At the new equilibrium quantity (P1, Q1), the original firm is earning zero economic
profits, and entry into the industry ceases. In (b) the opposite occurs. At P0 and Q0, the firm is
losing money. If you follow the dotted line above Q0, you can see that average cost is above price.
Losses induce firms to leave the industry. When they do, demand for the original firm rises to
D1, where once again the firm is earning zero economic profit.
Unlike a monopoly, with its high barriers to entry, a monopolistically
competitive firm with positive economic profits will attract competition.
When another competitor enters the market, the original firm’s perceived
demand curve shifts to the left, from D to D , and the associated marginal
0 1
Moving vertically up from that quantity on the new demand curve, the
optimal price is at P . 1
Self-Check Questions
$25.00 0 $130
$24.00 10 $275
$23.00 20 $435
$22.50 30 $610
$22.00 40 $800
$21.60 50 $1,005
$21.20 60 $1,225
Table 2.
References
Kantar Media. “Our Insights: Infographic—U.S. Advertising Year End
Trends Report 2012.” Accessed October 17, 2013.
http://kantarmedia.us/insight-center/reports/infographic-us-advertising-
year-end-trends-report-2012.
Statistica.com. 2015. “Number of Restaurants in the United States from
2011 to 2014.” Accessed March 27, 2015.
http://www.statista.com/statistics/244616/number-of-qsr-fsr-chain-
independent-restaurants-in-the-us/.
Glossary
differentiated product
a product that is perceived by consumers as distinctive in some way
imperfectly competitive
firms and organizations that fall between the extremes of monopoly
and perfect competition
monopolistic competition
many firms competing to sell similar but differentiated products
oligopoly
when a few large firms have all or most of the sales in an industry
Solutions
Answers to Self-Check Questions
1. An increase in demand will manifest itself as a rightward shift in the
demand curve, and a rightward shift in marginal revenue. The shift in
marginal revenue will cause a movement up the marginal cost curve to
the new intersection between MR and MC at a higher level of output.
The new price can be read by drawing a line up from the new output
level to the new demand curve, and then over to the vertical axis. The
new price should be higher. The increase in quantity will cause a
movement along the average cost curve to a possibly higher level of
average cost. The price, though, will increase more, causing an increase
in total profits.
2. As long as the original firm is earning positive economic profits, other
firms will respond in ways that take away the original firm’s profits.
This will manifest itself as a decrease in demand for the original firm’s
product, a decrease in the firm’s profit-maximizing price and a decrease
in the firm’s profit-maximizing level of output, essentially unwinding
the process described in the answer to question 1. In the long-run
equilibrium, all firms in monopolistically competitive markets will earn
zero economic profits.