MANOPOLISTIC COPMTEITION

A market structure in which several or many sellers each produce similar,

but slightly differentiated products. Each producer can set its price and
quantity without affecting the marketplace as a whole.

A monopolistically competitive market exists when a substantially large

number of firms serve a market with relatively
differentiated products.
B. An example would be merchandising firms of all types selling products
such as shoes, shirts, TV's, groceries, etc.
C. Product differentiation
1.Some feel it is real and important while others feel it is artificial and
unimportant.
2. Examples
a. Non-price competition
1. Product quality
2. Product image
3. Customer service
4. Store environment and image
b. Condition for sale
1. Mail order
2. Home delivery using the internet
3. Bidding on the internet
C. Some control over price exists and demand tends to be more elastic than
with monopoly or oligopoly markets.
III. Economic analysis of monopolistic competition
A. P is high compared to pure competition (P> MR = MC)
B. Quantity will be restricted causing ATC to be higher than that
indicated by the curve's lowest point.
C. Tends to be more competitive than monopoly and oligopoly.
D. Some believe economic profit tends toward zero as the number of firms
adjust to varying profit levels.
In discussing industries that are neither monopolies nor p-competitive,
economists have tended to begin from the four characteristics of a p-
competitive industry. We recall that those characteristics are:
• Many buyers and sellers
• A homogenous product
• Sufficient knowledge
• Free entry
Competition can be "imperfect" in an industry if the industry deviates from
any one of the four. Thus, if there are just a few firms (but more than one),
deviating from the first characteristic, the industry is said to be an
"oligopoly." Since the nineteen-twenties, economists have also discussed the
situation when an "industry" deviates only in the second characteristic. This
is called "monopolistic competition," and we have "monopolistic
competition" when a group of firms sell closely related, but not homogenous
products. Instead, the products are said to be "differentiated products." Thus,
the characteristics of "monopolistic competition" are:

• Many buyers and sellers

• Differentiated products
• Sufficient knowledge
• Free entry

To say that products are differentiated is to say that the products may be
(more or less) good substitutes, but they are not perfect substitutes. For an
example of a monopolistically competitive "industry" we may think of the
hairdressing industry. There are many hairdressers in the country, and most
hairdressing firms are quite small. There is free entry and it is at least
possible that people know enough about their hairdressing options so that
the "sufficient knowledge" condition is fulfilled. But the products of
different hairdressers are not perfect substitutes. At the very least, their
services are differentiated by location. A hairdresser in Center City
Philadelphia is not a perfect substitute for a hairdresser in the suburbs --
although they may be good substitutes from the point of view of a customer
who lives in the suburbs but works in Center City. Hairdressers' services
may be differentiated in other ways as well. Their styles may be different;
the decor of the salon may be different, and that may make a difference for
some customers; and even the quality of the conversation may make a
difference.

It sometimes happens in the reasonable dialog of economics that issues are

raised that cannot be fully resolved to everybody's satisfaction. That has
been the case with the theory of monopolistic competition. Some of the great
economists of the 1920's and 1930's began the study of monopolistic
competition. American economist Edward Chamberlin and British
economists Joan Robinson and Abba Lerner all made important
contributions to the theory, while British economist Roy Harrod and
American economist George Stigler criticized it. As we have just seen,
increasing differentiation of products could lead to nonprice competition
with increasing prices and costs. Critics argued that a firm that was unwise
enough to adopt this price-raising strategy would soon be undercut by a low-
cost producer before very long; in other words, that a high-price situation
could not be a long-run equilibrium. The critics also held that the
monopolistic competition theory was too imprecise. While it may not be
very easy to see, in this simple discussion, the p-competitive theory could be
restated in very precise ways. The theory of monopolistic competition was
harder to restate in precise terms. By about 1970, it seemed as if the critics
had won. But during the 1980's and 1990's, monopolistic competition theory
had made something of a comeback. Product differentiation and variety
seemed to important to leave out of economic theory, and economists found
ways to make this idea quite precise. It also seemed especially important in
international trade: when both the United States and Germany import
automobiles to one another, it must mean that automobiles are a
differentiated product, and that the American cars are different from the
German cars. The problem is that we still really do not know what that
implies for efficiency. The theorists of the 1990's tend to put a great deal of
stress on the tendency of nonprice competition to encourage innovation and
the introduction of new products, rather than any tendency to raise prices.
The discussion is still going on.

What we are pretty sure of is that product variety is important. But we have a lot to learn
about how the market system creates product variety, and whether it creates too much,
too little, or just about enough. Perhaps one of the readers of this book will discover the
answer to that question.

Product Differentiation
the word "industry" was put in quotes, when it referred to a group of firms
with product differentiation. That's because the boundaries of the industry
become much more vague when we talk about product differentiation. A
hairdresser in Center City Philadelphia and another in a Philadelphia suburb
may be pretty close substitutes -- but the Philadelphia hairdresser's service
will be a very poor substitute for the services of a hairdresser in Seattle! Are
they in the same industry? Or should we think of hairdressing industries as
localized, so that Philadelphia hairdressing is a different industry than
Seattle hairdressing? And, too: barbers may cut women's hair, and
hairdressers may cut men's hair. Are hairdressers and barbers part of the
same industry, or different industries? There really is no final answer to this
question, and some economists have avoided any reference to industries in
dealing with monopolistic competition. Instead they talk about "product
groups." A product group is a group of firms selling products that are
"good," but not necessarily "perfect" substitutes. And, of course, a product
group is not unique, since it depends on how "good" we require the
substitutes to be, so there will be broader and narrower product groups. Coke
and Pepsi are both members of the product group "cola drinks," while Coke,
Dr. Pepper, Sprite and Squirt are members of the broader product group
"carbonated soft drinks."

This illustrates another point. Product differentiation is characteristic of

monopolistic competition, but not limited to monopolistic competition.
Oligopolies, too, may have product differentiation. Cola drinks would
probably be thought of as a differentiated oligopoly, an oligopoly product
group, rather than a monopolistically competitive group.

And what about "free entry?" For monopolistic competition, that means free
entry into the "product group." Again, let's think of hairdressers as the
example. If a hairdresser is especially successful with a Seattle-punk style at
a certain location in Center City Philadelphia, there is nothing to prevent
other hairdressers from setting up at a nearby location, and cutting in a
similar style. In that sense, there is "free entry" into the product group. In
general, when one monopolistically competitive firm is quite profitable, we
may expect that other firms will set up in business producing similar
products, and established firms may change the characteristics of the
products they produce, to make those products more similar to the successful
one. In that sense, there is free entry into the monopolistically competitive
product group.

The Short Run

In the short run, then, the monopolistically competitive firm faces limited
competition. There are other firms that sell products that are good, but not
perfect, substitutes for the firm's own product. In the words of British
economist Joan Robinson, every firm has a monopoly of its own product.
When the product is differentiated, that means the firm has some monopoly
power -- maybe not much, if the competing products are close substitutes,
but some monopoly power, and that means we must use the monopoly
analysis, as if Figure 1 below.
 Figure 1: Monopolistic Competition

We see that, as usual in monopoly analysis, the marginal revenue is less than
the price. The firm will set its output so as to make marginal cost equal to
marginal revenue, and charge the corresponding price on the demand curve,
so that in this example, the monopoly sells 1000 units of output (per week,
perhaps) for a price of $85 per unit.

But this is just a short run situation. We see that the price is greater than the
average cost (which is $74 per unit, in this case) giving a profit of $11,000
per week. We remember too that this is economic profit -- net of all implicit
as well as explicit costs -- so this profitable performance will attract new
competition in the long run. What that means is that new firms will set up,
and existing firms will change their products, so that there will be more, and
closer, substitutes in the long run. That will shift the demand for this firm's
profits downward, and perhaps cause the cost curves to shift upward as well,
squeezing the profit margins.

The Long Run

In monopolistic competition, when one firm or product variety is profitable,
it will attract more competition -- more substitutes and closer substitutes for
the profitable product type. Thus, demand will shift downward and (perhaps)
costs will increase. This will go on as long as the firm and its product type
remain profitable. A new "long run equilibrium" is reached when
(economic) profits have been eliminated. This is shown in Figure 2:
Figure 2

In this example, the firm can break even by selling 935 units of output at a
price of $76 per unit. The profit -- zero -- is the greatest profit the firm can
make, so profit is being maximized (as usual) with the output that makes
MC=MR.

Zero (economic) profit is also the condition for long run equilibrium in a p-
competitive industry. But this equilibrium is not the ideal that the long run
equilibrium in a p-competitive industry is. Many economists feel that the
long run equilibrium in a monopolistic industry has some problems:

Inefficiency
Notice that, either in the long run or in the short, the price is greater
than marginal cost. But the condition for efficient production is that
price is equal to marginal cost. Thus, an individual firm's output is
less that would be efficient, according to the traditional standard.
Excess capacity
We see that, in the long run, the firm is not producing at the bottom of
its long run average cost curve. Instead, it is operating on a scale that
is smaller and less efficient -- the firm has a capacity to produce more
at a lower average cost. To put it a little differently, each firm is
serving a market that is too small, and there are too many firms, so
that the product group as a whole has the capacity to serve more
customers than there are -- excess capacity.
Advertising and nonprice competition
A firm in a p-competitive industry will not advertise at all. Why
should they? The p-competitive firm can sell all it wants to sell,
 without cutting its price, so why spend money to get more customers?
But the monopolistically competitive firm cannot sell all it wants
without cutting its price, and advertising to get more customers may
be more profitable than cutting price. Thus, economists expect to see
monopolistic competition associated with advertising. Moreover,
advertising seems to go along with differentiated products, and as a
profitable firm attracts more competition, with more substitutes and
closer substitutes for their product, the firm may feel that it needs to
spend more on advertising. (That's why the cost curve could be higher
in a long run equilibrium). In this context, advertising is seen as
wasteful.

Of course, all of this is controversial. Some economists have been quite

critical of the idea of monopolistic competition from the start. Here are some
responses the critics might make to these points.

Inefficiency

While the hypothetical monopolistically competitive firm does

operate inefficiently, it doesn't miss efficiency by much. The deviation
of marginal cost from marginal price, and of the firm's production and
price from the efficient, p-competitive quantities could be only a few
percent -- less than we can detect in practice. Thus, despite the
differentiation of products, the p-competitive theory may be a "good
enough" approximation, especially in the long run.

Excess capacity

Again, for concreteness, let's think of hairdressing as a typical

instance of "monopolistic competition." What this is telling us is that
if some of the existing hairdressing enterprises were combined, so that
there would be fewer hairdressers each serving a larger market, they
could serve that market at a lower cost and price. Perhaps; but some
consumers would lose out, since they would have to go further from
their homes or offices to find the nearest hairdresser. More generally,
getting rid of "excess capacity" means sacrificing variety -- and that's
a loss. Whose favorite is to be eliminated?
Advertising and nonprice competition

Actually, advertising is common in most industries, however,

competitive -- as a disequilibrium event. When price is a little above
equilibrium, it makes sense for a competitive firm to include
advertising it its competitive mix; but when price competition brings
the price down to its equilibrium level, sellers no longer have any
reason to compete for buyers -- either by price cuts or advertising or
any other way. In the real world, a competitive industry is always
reacting to changing events, always moving toward the equilibrium --
but it may never stay there for very long. And this advertising is
useful, in keeping consumers up to date about their opportunities. So
it is not clear that monopolistically competitive advertising is
something to be concerned about.

As we have seen before, economic theory favors price competition, while

nonprice competition -- by advertising and other means -- is often seen as a
mixed bag of good and bad. But some economists claim that monopolistic
competition promotes a particularly unfortunate kind of nonprice
competition.

Increasing Product Differentiation

A monopolistically competitive firm faces competition from other products
that are good substitutes for its own product type. One way that it might be
able to improve its profit margins is by changing its product type so that the
other products are less substitutable for it. This is "increasing the
differentiation of the product" or "(further) differentiating the product," and
may be accomplished by creating marketing, engineering redesign, or other
means.

How does "increasing the differentiation of the product" work in the model
of monopolistic competition? Thinking back to the section on elasticity, we
recall

• The more and the closer substitutes there are for a product, the more
elastic the demand for that product is.

So, if the effort to differentiate the product is successful, the elasticity of

demand for the product will be decreased. In turn, we recall
 • A less elastic demand is correlated with a steeper demand curve.

So we can visualize a more differentiated product as having a steeper

demand curve. That's the idea behind Figure 3:

Figure 3

In the figure, the firm has succeeded in further differentiating its product,
(starting from the long-run equilibrium we saw before) without losing any of
their customers. This substitutes the lighter green New Demand curve for the
old demand curve D. As a result, referring to the new marginal revenue
curve (which is not shown, to keep this complicated diagram from being any
more complicated) the firm will maximize profits by selling 642.5 units at
$110 each for profits somewhat over $70,000 at an average cost of $90 per
unit. That compares with zero profits in the long run equilibrium on demand
curve D

But, of course, it is still a short run gain. In the long run, the new product
type will attract new competition, and profits will again be eroded. That's
life in a competitive business. Profits in the short run beats no profits at all.

Increasing Product Differentiation:

Long Run
If the increasing product differentiation is successful in increasing profits in
the long run, it will attract new competition until the economic profits are
wiped out in the new long run equilibrium. Since all of the firms are trying
to increase the differentiation of their products, the competing products are
not closer substitutes, but just because of increasing numbers of firms,
demand decreases and profits disappear. Here is the way the firm's new long
run equilibrium would look:

Figure 4

Now we see zero profits on the new demand curve, with sales of 610 units at
a price of $99 per unit. Comparing the two long run equilibria, we see that in
this case, nonprice competition has increased the price and cost from $76 per
unit to $99 per unit, while production has been cut back from 935 units to
610 units. This doesn't look very good for monopolistic competition.