Lesson 1, Topic 1
In Progress

Monopolistic Competition


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Monopolistic competition is a market structure which combines elements of monopoly and competitive markets. Essentially a monopolistic competitive market is one with freedom of entry and exit, but firms can differentiate their products. Therefore, they have an inelastic demand curve and so they can set prices. However, because there is freedom of entry, supernormal profits will encourage more firms to enter the market leading to normal profits in the long term.

A monopolistic competitive industry has the following features:

  • Manyfirms.
    • Freedom of entry andexit.
    • Firms produce differentiatedproducts.
    • 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 shortterm
    • Firms are allocatively and productivelyinefficient.
Diagram monopolistic competition short run

In the short run, the diagram for monopolistic competition is the same as for a monopoly.

The firm maximizes profit where MR=MC. This is at output Q1 and price P1, leading to supernormal profit

Monopolistic competition long run

In the long-run, supernormal profit encourages new firms to enter. This reduces demand for existing firms and leads to normal profit.

Efficiency of firms in monopolistic competition

  • Allocative inefficient. The above diagrams show a price set above marginalcost
    • Productive inefficiency. The above diagram shows a firm not producing on the lowest point of ACcurve
    • Dynamic efficiency. This is possible as firms have profit to invest in researchand development.
    • X-efficiency. This is possible as the firm does face competitive pressures to cut costand provide betterproducts.
Examples of monopolistic competition
  • Restaurants – restaurants compete on quality of food as much as price. Product differentiation is a key element of the business. There are relatively low barriers to entry in setting up a newrestaurant.
    • Hairdressers. A service which will give firms a reputation for the quality of their hair- cutting.
    • Clothing. Designer label clothes are about the brand and productdifferentiation
    • TV programmes – globalization has increased the diversity of tv programmes from networks around the world. Consumers can choose between domestic channels butalso imports from other countries and new services, such asNetflix.
Limitations of the model of monopolistic competition
  • Some firms will be better at brand differentiation and therefore, in the real world, they will be able to make supernormalprofit.
    • New firms will not be seen as a closesubstitute.
    • There is considerable overlap with oligopoly – except the model of monopolistic competition assumes no barriers to entry. In the real world, there are likely to be atleast some barriers to entry
    • If a firm has strong brand loyalty and product differentiation – this itself becomesa barrier to entry. A new firm can’t easily capture the brandloyalty.
    • Many industries, we may describe as monopolistically competitive are very profitable,so the assumption of normal profits is toosimplistic.
Key difference with monopoly

In monopolistic competition there are no barriers to entry. Therefore in long run, the market will be competitive, with firms making normal profit.

Key difference with perfect competition

In Monopolistic competition, firms do produce differentiated products, therefore, they are not price takers (perfectly elastic demand). They have inelastic demand.

New trade theory and monopolistic competition

New trade theory places importance on the model of monopolistic competition for explaining trends in trade patterns. New trade theory suggests that a key element of product development is the drive for product differentiation – creating strong brands and new features for products.

Therefore, specialisation doesn’t need to be based on traditional theories of comparative advantage, but we can have countries both importing and exporting the same good. For example, we import Italian fashion labels and export British fashion labels. To consumers, the importance is the choice of goods.

Characteristics or Main Features of Monopolistic Competition:

Important characteristics of monopolistic competition are as follows:

  1. Less Number of Buyers andSellers:

In this market neither buyers nor sellers are too many as under perfect competition nor there is only one seller as under monopoly. Mostly, it is a situation in between. Every producer for his produced commodity has some special buyers. Every consumer and seller can influence demand and supply in the market.

  • Difference in the Quality and Shape of theGoods:

Although the commodities produced by different producers can serve as perfect substitutes to those produced by others, yet they are different in colour, form, packing, design, name etc. So there is product differentiation in the market.

  • Lack of Knowledge on the Part ofConsumers:

Neither consumers nor sellers have full knowledge of market conditions, so there is international difference in the price of goods from those of others.

  • High TransportationCost:

In this high transportation cost play an important role in order to create discrimination among commodities. Similar goods because of different transport costs are bought and sold at different prices.

  • Advertisement:

Here, advertisement plays an important role because buyers are influenced to prefer by advertisement, which plays upon their mind and makes them the product of one firm to those of another. Through advertisement, they are brought to his notice through radio, television and other audio-visual aids in a more pleasing and more forceful manner. Thus, rival firms compete against each other in quantity, in facilities as well as in price.

  • Ignorance of theBuyers:

There are some people who think that high priced goods will be better and of higher quality. So, they avoid buying low priced goods.

  • Differences in the Establishment ofIndustry:

In the imperfect competitive market, there is neither freedom of entry or exit as is under perfect competition nor there is perfect control as in monopoly but there are some restrictions on the entry of industry only.

ACTIVITY 4.5

  1. Explain the nature of monopolistic competition in both long-run and short-run.
  2. Give some examples of monopolisticcompetition.
  3. What are the limitations of the monopolistic competitionmodel?

Write a note on trade theory and monopolisticcompetitions

References

  1. E.F. Brigham and B Shipley, Cassell (2016), Macroeconomics for Managers, 7th Edition, WadsworthPublishing.
  2. Raymond A. Barnett , Michael R. Ziegler , Karl E. Byleen, 2014, Calculus for Business, Economics, Life Sciences, and Social Sciences (13th Edition) 13thEdition.
  3. Chang H.J., (2014). Economics: The User’s Guide: A Pelican Introduction. Pelican. Journal of Economics and Business –Elsevier.