Monopolistic competition

Monopolistic competition

Overview
Monopolistic competition is imperfect competition
Imperfect competition
In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...

 where many competing producers sell products that are differentiated
Differentiation (economics)
Differentiation is a concept used in business strategy and describes one of the three ways to establish competitive advantage.Differentiation advantage occurs when a firm delivers greater services for a non-unlimited higher price than its competitors...

 from one another (that is, the products are substitutes
Substitute good
In economics, one way we classify goods is by examining the relationship of the demand schedules when the price of one good changes. This relationship between demand schedules leads economists to classify goods as either substitutes or complements. Substitute goods are goods which, as a result...

 but, because of differences such as branding, not exactly alike). 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. In a monopolistically competitive market, firms can behave like monopolies in the short run, including by using market power to generate profit.
Discussion
Ask a question about 'Monopolistic competition'
Start a new discussion about 'Monopolistic competition'
Answer questions from other users
Full Discussion Forum
 
Unanswered Questions
Recent Discussions
Encyclopedia
Monopolistic competition is imperfect competition
Imperfect competition
In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...

 where many competing producers sell products that are differentiated
Differentiation (economics)
Differentiation is a concept used in business strategy and describes one of the three ways to establish competitive advantage.Differentiation advantage occurs when a firm delivers greater services for a non-unlimited higher price than its competitors...

 from one another (that is, the products are substitutes
Substitute good
In economics, one way we classify goods is by examining the relationship of the demand schedules when the price of one good changes. This relationship between demand schedules leads economists to classify goods as either substitutes or complements. Substitute goods are goods which, as a result...

 but, because of differences such as branding, not exactly alike). 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. In a monopolistically competitive market, firms can behave like monopolies in the short run, including by using market power to generate profit. In the long run, however, other firms enter the market and the benefits of differentiation decrease with competition; the market becomes more like a perfectly competitive
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

 one where firms cannot gain economic profit. In practice, however, if consumer rationality/innovativeness is low and heuristics are preferred, monopolistic competition can fall into natural monopoly
Natural monopoly
A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...

, even in the complete absence of government intervention. In the presence of coercive government, monopolistic competition will fall into government-granted monopoly
Government-granted monopoly
In economics, a government-granted monopoly is a form of coercive monopoly by which a government grants exclusive privilege to a private individual or firm to be the sole provider of a good or service; potential competitors are excluded from the market by law, regulation, or other mechanisms of...

. 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
Cereal
Cereals are grasses cultivated for the edible components of their grain , composed of the endosperm, germ, and bran...

, clothing
Clothing
Clothing refers to any covering for the human body that is worn. The wearing of clothing is exclusively a human characteristic and is a feature of nearly all human societies...

, 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). Joan Robinson
Joan Robinson
Joan Violet Robinson FBA was a post-Keynesian economist who was well known for her knowledge of monetary economics and wide-ranging contributions to economic theory...

 is also credited as an early pioneer of the concept.

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.
  • There are few barriers to entry
    Barriers to entry
    In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...

     and exit.
  • Producers have a degree of control over price.


The long-run characteristics of a monopolistically competitive market are almost the same as a perfectly competitive market. Two differences between the two are that monopolistic competition produces heterogeneous products and that monopolistic competition involves a great deal of non-price competition, which is based on subtle product differentiation. A firm making profits in the short run will nonetheless only break even
Break Even
Break Even are an Australian hardcore band from Perth, Western Australia.-History:Forming in the suburbs of Perth in 2005, Break Even have released two successful releases and toured with the biggest names in local and international hardcore....

 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 illustrates the amount of influence the firm has 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
Price elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price...

 demand schedule.

Major characteristics


There are six characteristics of monopolistic competition (MC):
  • Product differentiation
  • Many firms
  • Free entry and exit in the long run
  • Independent decision making
  • Market Power
  • Buyers and Sellers have perfect information

Product differentiation


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. MC goods are best described as close but imperfect substitutes. 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 basically the same - to move people and objects from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles such as motor scooters, motor cycles, trucks, cars and SUVs and many variations even within these categories.

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". 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. Also the greater the degree of product differentiation - the more the firm can separate itself from the pack - the fewer firms there will be at market equilibrium.

Free entry and exit


In the long run there is free entry and exit. There are numerous firms waiting 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.
The cost of entering and exit is very low.

Independent decision making


Each MC firm independently sets the terms of exchange for its product. The firm gives no consideration to what effect its decision may have on competitors. 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 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. 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


No sellers or buyers have complete market information, like market demand or market supply.
Market Structure comparison
Number of firms Market power Elasticity of demand Product differentiation Excess profits Efficiency Profit maximization condition Pricing power
Perfect Competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

Infinite None Perfectly elastic None No Yes P=MR=MC Price taker
Monopolistic competition Many Low Highly elastic (long run) High Yes/No (Short/Long) No MR=MC Price setter
Monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

One High Relatively inelastic Absolute (across industries) Yes No MR=MC Price setter

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. A 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.

Problems



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 far exceed the benefits of such regulation. The government would have to regulate all firms that sold heterogeneous products—an impossible proposition in a market economy
Market economy
A market economy is an economy in which the prices of goods and services are determined in a free price system. This is often contrasted with a state-directed or planned economy. Market economies can range from hypothetically pure laissez-faire variants to an assortment of real-world mixed...

. 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
Advertising
Advertising is a form of communication used to persuade an audience to take some action with respect to products, ideas, or services. Most commonly, the desired result is to drive consumer behavior with respect to a commercial offering, although political and ideological advertising is also common...

 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. 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.

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.

Examples


In many U.S. markets, 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. Toothpastes, toilet papers, computer software and operating systems are examples of differentiated products.

See also


  • Atomistic market
    Atomistic market
    In an atomistic market, each seller's size is so small, relative to the market as a whole, that it has no appreciable effect on price. As a result, such sellers have no market power. This structure is consistent with perfect competition....

  • Government-granted monopoly
    Government-granted monopoly
    In economics, a government-granted monopoly is a form of coercive monopoly by which a government grants exclusive privilege to a private individual or firm to be the sole provider of a good or service; potential competitors are excluded from the market by law, regulation, or other mechanisms of...

  • Imperfect competition
    Imperfect competition
    In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...

  • Microeconomics
    Microeconomics
    Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

  • Monopolistic competition in international trade
    Monopolistic competition in international trade
    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...

  • Monopoly
    Monopoly
    A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

  • Natural monopoly
    Natural monopoly
    A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...

  • Oligopoly
    Oligopoly
    An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...

  • Perfect competition
    Perfect competition
    In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

  • Simulations and games in economics education
    Simulations and games in economics education
    A simulation game is "a game that contains a mixture of skill, chance, and strategy to simulate an aspect of reality, such as a stock exchange". Similarly, Ruohomaki states that "a simulation game combines the features of a game with those of a simulation...


External links