Boundless EconomicsMonopolistic Competition
Monopolistic Competition
Defining Monopolistic CompetitionMonopolistic competition is a type of imperfect competition such that manyproducers sell products that are differentiated from one another.
Learning ObjectivesEvaluate the characteristics and outcomes of markets with imperfectcompetition
Key TakeawaysKey PointsMonopolistic competition is different from a monopoly. A monopoly existswhen a person or entity is the exclusive supplier of a good or service in amarket.Markets that have monopolistic competition are inefficient for two reasons.First, at its optimum output the firm charges a price that exceeds marginal costs.The second source of inefficiency is the fact that these firms operate with excesscapacity.Monopolistic competitive markets have highly differentiated products; havemany firms providing the good or service; firms can freely enter and exits in thelong-run; firms can make decisions independently; there is some degree ofmarket power; and buyers and sellers have imperfect information.
Key Termsmonopoly: A market where one company is the sole supplier.
Monopolistic competition: A type of imperfect competition such that one ortwo producers sell products that are differentiated from one another as goodsbut not perfect substitutes (such as from branding, quality, or location).
Monopolistic CompetitionMonopolistic competition is a type of imperfect competition such that manyproducers sell products that are differentiated from one another as goods butnot perfect substitutes (such as from branding, quality, or location). Inmonopolistic competition, a firm takes the prices charged by its rivals as givenand ignores the impact of its own prices on the prices of other firms.
Unlike in perfect competition, firms that are monopolistically competitivemaintain spare capacity. Models of monopolistic competition are often used tomodel industries. Textbook examples of industries with market structures similarto monopolistic competition include restaurants, cereal, clothing, shoes, andservice industries in large cities.
Clothing: The clothing industry is monopolistically competitive becausefirms have differentiated products and market power.
Monopolistic competition is different from a monopoly. A monopoly existswhen a person or entity is the exclusive supplier of a good or service in amarket. The demand is inelastic and the market is inefficient.
Monopolistic competitive markets:
have products that are highly differentiated, meaning that there is a perceptionthat the goods are different for reasons other than price;have many firms providing the good or service;firms can freely enter and exits in the long-run;firms can make decisions independently;
there is some degree of market power, meaning producers have some controlover price; andbuyers and sellers have imperfect information.
Sources of Market InefficiencyMarkets that have monopolistic competition are inefficient for two reasons. Thefirst source of inefficiency is due to the fact that at its optimum output, the firmcharges a price that exceeds marginal costs. The monopolistic competitive firmmaximizes profits where marginal revenue equals marginal cost. A monopolisticcompetitive firm's demand curve is downward sloping, which means it willcharge a price that exceeds marginal costs. The market power possessed by amonopolistic competitive firm means that at its profit maximizing level ofproduction there will be a net loss of consumer and producer surplus.
The second source of inefficiency is the fact that these firms operate with excesscapacity. The firm's profit maximizing output is less than the output associatedwith minimum average cost. All firms, regardless of the type of market itoperates in, will produce to a point where demand or price equals average cost.In a perfectly competitive market, this occurs where the perfectly elastic demandcurve equals minimum average cost. In a monopolistic competitive market, thedemand curve is downward sloping. In the long run, this leads to excesscapacity.
Product DifferentiationProduct differentiation is the process of distinguishing a product or service fromothers to make it more attractive to a target market.
Learning ObjectivesDefine product differentiation
Key Takeaways
Key PointsDifferentiation occurs because buyers perceive a difference between products.Causes of differentiation include functional aspects of the product or service,how it is distributed and marketed, and who buys it.Differentiation affects performance primarily by reducing direct competition. Asthe product becomes more different, categorization becomes more difficult, andthe product draws fewer comparisons with its competition.There are three types of product differentiation: simple, horizontal, and vertical.
Key Termsproduct differentiation: Perceived differences between the product of one firmand that of its rivals so that some customers value it more.
One of the defining traits of a monopolistically competitive market is that thereis a significant amount of non- price competition. This means that productdifferentiation is key for any monopolistically competitive firm. Productdifferentiation is the process of distinguishing a product or service from othersto make it more attractive to a target market.
Kool-Aid: Kool-Aid is an individualbrand that competes with Kraft'sother brand (Tang).
Although research in a niche market may result in changing a product in orderto improve differentiation, the changes themselves are not differentiation.Marketing or product differentiation is the process of describing the differencesbetween products or services, or the resulting list of differences; differentiationis not the process of creating the differences between the products. Productdifferentiation is done in order to demonstrate the unique aspects of a firm'sproduct and to create a sense of value.
In economics, successful product differentiation is inconsistent with theconditions of perfect competition, which require products of competing firms tobe perfect substitutes.
Consumers do not need to know everything about the product fordifferentiation to work. So long as the consumers perceive that there is adifference in the products, they do not need to know how or why one product
might be of higher quality than another. For example, a generic brand of cerealmight be exactly the same as a brand name in terms of quality. However,consumers might be willing to pay more for the brand name despite the factthat they cannot identify why the more expensive cereal is of higher "quality."
There are three types of product differentiation:
Simple: the products are differentiated based on a variety of characteristics;Horizontal: the products are differentiated based on a single characteristic, butconsumers are not clear on which product is of higher quality; andVertical: the products are differentiated based on a single characteristic andconsumers are clear on which product is of higher quality.
Differentiation occurs because buyers perceive a difference. Drivers ofdifferentiation include functional aspects of the product or service, how it isdistributed and marketed, and who buys it. The major sources of productdifferentiation are as follows:
Differences in quality, which are usually accompanied by differences in price;Differences in functional features or design;Ignorance of buyers regarding the essential characteristics and qualities ofgoods they are purchasing;Sales promotion activities of sellers, particularly advertising; andDifferences in availability (e.g. timing and location).
The objective of differentiation is to develop a position that potential customerssee as unique. Differentiation affects performance primarily by reducing directcompetition. As the product becomes more different, categorization becomesmore difficult, and the product draws fewer comparisons with its competition. Asuccessful product differentiation strategy will move the product from
competing on price to competing on non-price factors.
Demand CurveThe demand curve in a monopolistic competitive market slopes downward,which has several important implications for firms in this market.
Learning ObjectivesExplain how the shape of the demand curve affects the firms that exist in amarket with monopolistic competition
Key TakeawaysKey PointsThe downward slope of a monopolistically competitive demand curve signifiesthat the firms in this industry have market power.Market power allows firms to increase their prices without losing all of theircustomers.The downward slope of the demand curve contributes to the inefficiency of themarket, leading to a loss in consumer surplus, deadweight loss, and excessproduction capacity.
Key Termsmarket power: The ability of a firm to profitably raise the market price of agood or service over marginal cost. A firm with total market power can raiseprices without losing any customers to competitors.elastic: Sensitive to changes in price.
The demand curve of a monopolistic competitive market slopes downward. Thismeans that as price decreases, the quantity demanded for that good increases.While this appears to be relatively straightforward, the shape of the demandcurve has several important implications for firms in a monopolistic competitive
market.
Quantity
MC
D
Pric
e
Pc
Pm
Qm Qc
Deadweight loss
MR
Consumer surplus
Producersurplus
Monopolistic Competition: As you cansee from this chart, the demand curve(marked in red) slopes downward,signifying elastic demand.
Market PowerThe demand curve for an individual firm is downward sloping in monopolisticcompetition, in contrast to perfect competition where the firm's individualdemand curve is perfectly elastic. This is due to the fact that firms have marketpower: they can raise prices without losing all of their customers. In this type ofmarket, these firms have a limited ability to dictate the price of its products; afirm is a price setter not a price taker (at least to some degree). The source ofthe market power is that there are comparatively fewer competitors than in acompetitive market, so businesses focus on product differentiation, ordifferences unrelated to price. By differentiating its products, firms in amonopolistically competitive market ensure that its products are imperfectsubstitutes for each other. As a result, a business that works on its branding can
increase its prices without risking its consumer base.
Inefficiency in the MarketMonopolistically competitive firms maximize their profit when they produce at alevel where its marginal costs equals its marginal revenues. Because theindividual firm's demand curve is downward sloping, reflecting market power,the price these firms will charge will exceed their marginal costs. Due to howproducts are priced in this market, consumer surplus decreases below thepareto optimal levels you would find in a perfectly competitive market, at leastin the short run. As a result, the market will suffer deadweight loss. The suppliersin this market will also have excess production capacity.
Short Run Outcome of Monopolistic CompetitionMonopolistic competitive markets can lead to significant profits in the short-run, but are inefficient.
Learning ObjectivesExamine the concept of the short run and how it applies to firms in amonopolistic competition
Key TakeawaysKey PointsThe "short run" is the time period when one factor of production is fixed interms of costs, while the other elements of production are variable.Like monopolies, the suppliers in monopolistic competitive markets are pricemakers and will behave similarly in the short-run.Also like a monopoly, a monopolastic competitive firm will maximize its profitswhen its marginal revenues equals its marginal costs.
Key Terms
short-run: The conceptual time period in which at least one factor ofproduction is fixed in amount and others are variable in amount.
In terms of production and supply, the "short run" is the time period when onefactor of production is fixed in terms of costs while the other elements ofproduction are variable. The most common example of this is the production ofa good that requires a factory. If demand spikes, in the short run you will onlybe able to produce the amount of good that the capacity of the factory allows.This is because it takes a significant amount of time to either build or acquire anew factory. If demand for the good plummets you can cut production in thefactory, but will still have to pay the costs of maintaining the factory and theassociated rent or debt associated with acquiring the factory. You could sell thefactory, but again that would take a significant amount of time. The "short run"is defined by how long it would take to alter that "fixed" aspect of production.
In the short run, a monopolistically competitive market is inefficient. It does notachieve allocative nor productive efficiency. Also, since a monopolisticcompetitive firm has powers over the market that are similar to a monopoly, itsprofit maximizing level of production will result in a net loss of consumer andproducer surplus, creating deadweight loss.
Setting a Price and Determining ProfitLike monopolies, the suppliers in monopolistic competitive markets are pricemakers and will behave similarly in the short-run. Also like a monopoly, amonopolistic competitive firm will maximize its profits by producing goods tothe point where its marginal revenues equals its marginal costs. The profitmaximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve. The profit thefirm makes is the the amount of the good produced multiplied by the differencebetween the price minus the average cost of producing the good..
Short Run Equilibrium Under Monopolistic Competition: As you can seefrom the chart, the firm will produce the quantity (Qs) where the marginalcost (MC) curve intersects with the marginal revenue (MR) curve. The price isset based on where the Qs falls on the average revenue (AR) curve. Theprofit the firm makes in the short term is represented by the grey rectangle,or the quantity produced multiplied by the difference between the price andthe average cost of producing the good.
Since monopolistically competitive firms have market power, they will produceless and charge more than a firm would under perfect competition. This causesdeadweight loss for society, but, from the producer's point of view, is desirablebecause it allows them to earn a profit and increase their producer surplus.
Because of the possibility of large profits in the short-run and relatively lowbarriers of entry in comparison to perfect markets, markets with monopolistic
competition are very attractive to future entrants.
Long Run Outcome of Monopolistic CompetitionIn the long run, firms in monopolistic competitive markets are highly inefficientand can only break even.
Learning ObjectivesExplain the concept of the long run and how it applies to a firms in monopolisticcompetition
Key TakeawaysKey PointsIn terms of production and supply, the " long-run " is the time period when allaspects of production are variable and can therefore be adjusted to meet shiftsin demand.Like monopolies, the suppliers in monopolistic competitive markets are pricemakers and will behave similarly in the long-run.Like a monopoly, a monopolastic competitive firm will maximize its profits byproducing goods to the point where its marginal revenues equals its marginalcosts.In the long-run, the demand curve of a firm in a monopolistic competitivemarket will shift so that it is tangent to the firm's average total cost curve. As aresult, this will make it impossible for the firm to make economic profit; it willonly be able to break even.
Key Termslong-run: The conceptual time period in which there are no fixed factors ofproduction.
In terms of production and supply, the "long-run" is the time period when thereis no factor that is fixed and all aspects of production are variable and cantherefore be adjusted to meet shifts in demand. Given a long enough timeperiod, a firm can take the following actions in response to shifts in demand:
Enter an industry;Exit an industry;Increase its capacity to produce more; andDecrease its capacity to produce less.
In the long-run, a monopolistically competitive market is inefficient. It achievesneither allocative nor productive efficiency. Also, since a monopolisticcompetitive firm has power over the market that is similar to a monopoly, itsprofit maximizing level of production will result in a net loss of consumer andproducer surplus.
Setting a Price and Determining ProfitLike monopolies, the suppliers in monopolistic competitive markets are pricemakers and will behave similarly in the long-run. Also like a monopoly, amonopolistic competitive firm will maximize its profits by producing goods tothe point where its marginal revenues equals its marginal costs. The profitmaximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.
While a monopolistic competitive firm can make a profit in the short-run, theeffect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading toan increase in average total cost. The decrease in demand and increase in costcauses the long run average cost curve to become tangent to the demand curveat the good's profit maximizing price. This means two things. First, that the firmsin a monopolistic competitive market will produce a surplus in the long run.
Second, the firm will only be able to break even in the long-run; it will not beable to earn an economic profit.
Long Run Equilibrium of Monopolistic Competition: In the long run, afirm in a monopolistic competitive market will product the amount of goodswhere the long run marginal cost (LRMC) curve intersects marginal revenue(MR). The price will be set where the quantity produced falls on the averagerevenue (AR) curve. The result is that in the long-term the firm will breakeven.Monopolistic Competition Compared to Perfect CompetitionThe key difference between perfectly competitive markets and monopolisticallycompetitive ones is efficiency.
Learning Objectives
Differentiate between monopolistic competition and perfect competition
Key TakeawaysKey PointsPerfectly competitive markets have no barriers of entry or exit. Monopolisticallycompetitive markets have a few barriers of entry and exit.The two markets are similar in terms of elasticity of demand, a firm 's ability tomake profits in the long-run, and how to determine a firm's profit maximizingquantity condition.In a perfectly competitive market, all goods are substitutes. In a monopolisticallycompetitive market, there is a high degree of product differentiation.
Key Termsperfect competition: A type of market with many consumers and producers, allof whom are price takers
Perfect competition and monopolistic competition are two types of economicmarkets.
SimilaritiesOne of the key similarities that perfectly competitive and monopolisticallycompetitive markets share is elasticity of demand in the long-run. In bothcircumstances, the consumers are sensitive to price; if price goes up, demandfor that product decreases. The two only differ in degree. Firm's individualdemand curves in perfectly competitive markets are perfectly elastic, whichmeans that an incremental increase in price will cause demand for a product tovanish ). Demand curves in monopolistic competition are not perfectly elastic:due to the market power that firms have, they are able to raise prices withoutlosing all of their customers.
Demand curve in a perfectly competitive market: This is the demandcurve in a perfectly competitive market. Note how any increase in pricewould wipe out demand.
Also, in both sets of circumstances the suppliers cannot make a profit in thelong-run. Ultimately, firms in both markets will only be able to break even byselling their goods and services.
Both markets are composed of firms seeking to maximize their profits. In bothof these markets, profit maximization occurs when a firm produces goods tosuch a level so that its marginal costs of production equals its marginal
revenues.
DifferencesOne key difference between these two set of economic circumstances isefficiency. A perfectly competitive market is perfectly efficient. This means thatthe price is Pareto optimal, which means that any shift in the price would benefitone party at the expense of the other. The overall economic surplus, which isthe sum of the producer and consumer surpluses, is maximized. The supplierscannot influence the price of the good or service in question; the marketdictates the price. The price of the good or service in a perfectly competitivemarket is equal to the marginal costs of manufacturing that good or service.
In a monopolistically competitive market the price is higher than the marginalcost of producing the good or service and the suppliers can influence the price,granting them market power. This decreases the consumer surplus, and byextension the market's economic surplus, and creates deadweight loss.
Another key difference between the two is product differentiation. In a perfectlycompetitive market products are perfect substitutes for each other. But inmonopolistically competitive markets the products are highly differentiated. Infact, firms work hard to emphasize the non-price related differences betweentheir products and their competitors'.
A final difference involves barriers to entry and exit. Perfectly competitivemarkets have no barriers to entry and exit; a firm can freely enter or leave anindustry based on its perception of the market's profitability. In a monopolisticcompetitive market there are few barriers to entry and exit, but still more than ina perfectly competitive market.
Efficiency of Monopolistic CompetitionMonopolistic competitive markets are never efficient in any economic sense ofthe term.
Learning ObjectivesDiscuss the effect monopolistic competition has on overall market efficiency
Key TakeawaysKey PointsBecause a good is always priced higher than its marginal cost, amonopolistically competitive market can never achieve productive or allocativeefficiency.Suppliers in monopolistically competitive firms will produce below theircapacity.Because monopolistic firms set prices higher than marginal costs, consumersurplus is significantly less than it would be in a perfectly competitive market.This leads to deadweight loss and an overall decrease in economic surplus.
Key Termsconsumer surplus: The difference between the maximum price a consumer iswilling to pay and the actual price they do pay.producer surplus: The amount that producers benefit by selling at a marketprice that is higher than the lowest price at which they would be willing to sell.
Monopolistically competitive markets are less efficient than perfectlycompetitive markets.
Producer and Consumer SurplusIn terms of economic efficiency, firms that are in monopolistically competitivemarkets behave similarly as monopolistic firms. Both types of firms' profitmaximizing production levels occur when their marginal revenues equals theirmarginal costs. This quantity is less than what would be produced in a perfectlycompetitive market. It also means that producers will supply goods below their
manufacturing capacity.
Firms in a monopolistically competitive market are price setters, meaning theyget to unilaterally charge whatever they want for their goods without beinginfluenced by market forces. In these types of markets, the price that willmaximize their profit is set where the profit maximizing production level falls onthe demand curve.This price exceeds the firm's marginal costs and is higherthan what the firm would charge if the market was perfectly competitive. Thismeans two things:
Consumers will have to pay a higher price than they would in a perfectlycompetitive market, leading to a significant decline in consumer surplus; andProducers will sell less of their goods than they would have in a perfectlycompetitive market, which could offset their gains from charging a higher priceand could result in a decline in producer surplus.
Regardless of whether there is a decline in producer surplus, the loss inconsumer surplus due to monopolistic competition guarantees deadweight lossand an overall loss in economic surplus.
Quantity
MC
D
Pric
e
Pc
Pm
Qm Qc
Deadweight loss
MR
Consumer surplus
Producersurplus
Inefficiency in MonopolisticCompetition: Monopolisticcompetition creates deadweight lossand inefficiency, as represented bythe yellow triangle. The quantity isproduced when marginal revenueequals marginal cost, or where thegreen and blue lines intersect. Theprice is determined based on wherethe quantity falls on the demandcurve, or the red line. In the shortrun, the monopolistic competitionmarket acts like a monopoly.Productive and Allocative EfficiencyProductive efficiency occurs when a market is using all of its resourcesefficiently. This occurs when a product's price is set at its marginal cost, whichalso equals the product's average total cost. In a monopolistic competitivemarket, firms always set the price greater than their marginal costs, whichmeans the market can never be productively efficient.
Allocative efficiency occurs when a good is produced at a level that maximizessocial welfare. This occurs when a product's price equals its marginal benefits,which is also equal to the product's marginal costs. Again, since a good's pricein a monopolistic competitive market always exceeds its marginal cost, themarket can never be allocatively efficient.
Advertising and Brand Management in Monopolistic CompetitionAdvertising and branding help firms in monopolistic competitive marketsdifferentiate their products from those of their competitors.
Learning Objectives
Evaluate whether advertising is beneficial or detrimental to consumers
Key TakeawaysKey PointsA company's brand can help promote quality in that company's products.Advertising helps inform consumers about products, which decreases selectioncosts.Costs associated with advertising and branding include higher prices, customersmislead by false advertisements, and negative societal affects such asperpetuating stereotypes and spam.
Key Termsbrand: The reputation of an organization, a product, or a person among somesegment of the population.advertising: Communication with the purpose of influencing potentialcustomers about products and services
One of the characteristics of a monopolistic competitive market is that each firmmust differentiate its products. Two ways to do this is through advertising andcultivating a brand. Advertising is a form of communication meant to inform,educate, and influence potential customers about products and services.Advertising is generally used by businesses to cultivate a brand. A brand is acompany's reputation in relation to products or services sold under a specificname or logo.
Listerine advertisement, 1932: From 1921 until the mid-1970s, Listerine wasalso marketed as preventive and a remedy for colds and sore throats. In 1976, theFederal Trade Commission ruled that these claims were misleading, and thatListerine had "no efficacy" at either preventing or alleviating the symptoms ofsore throats and colds. Warner-Lambert was ordered to stop making the claimsand to include in the next $10.2 million dollars of Listerine ads specific mentionthat "contrary to prior advertising, Listerine will not help prevent colds or sorethroats or lessen their severity. "Benefits of Advertising and BrandingThe purpose of the brand is to generate an immediate positive reaction fromconsumers when they see a product or service being sold under a certain namein order to increase sales. A brand and the associated reputation are built onadvertising and consumers' past experiences with the products associated withthat brand.
Reputation among consumers is important to a monopolistically competitivefirm because it is arguably the best way to differentiate itself from itscompetitors. However, for that reputation to be maintained, the firm mustensure that the products associated with the brand name are of the highestquality. This standard of quality must be maintained at all times because it onlytakes one bad experience to ruin the value of the brand for a segment ofconsumers. Brands and advertising can thus help guarantee quality products forconsumers and society at large.
Advertising is also valuable to society because it helps inform consumers.Markets work best when consumers are well informed, and advertising providesthat information. Advertising and brands can help minimize the costs ofchoosing between different products because of consumers' familiarity with thefirms and their quality.
Finally, advertising allows new firms to enter into a market. Consumers might be
hesitant to purchase products with which they are unfamiliar. Advertising caneducate and inform those consumers, making them comfortable enough to givethose products a try.
Costs of Advertising and BrandingThere are some concerns about how advertising can harm consumers andsociety as well. Some believe that advertising and branding induces customersto spend more on products because of the name associated with them ratherthan because of rational factors. Further, there is no guarantee thatadvertisements accurately describe products; they can mislead consumers.Finally, advertising can have negative societal effects such as the perpetuationof negative stereotypes or the nuisance of "spam. "
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