MONOPOLISTIC COMPETITION

by modi Sun Oct 27, 2013 1:41 pm

MICROECONOMIC THEORY – PRODUCT MARKETS

(continued)

MONOPOLISTIC COMPETITION

Previously opposing ends of market structure (degree of competition) were discussed.
The market structure with the highest degree of competition, Perfect Competition, was
discussed as was Pure Monopoly, a market structure with no competition. In this section,
the market structure of monopolistic competition which lies between perfect competition
and perfect monopoly is discussed.

MONOPOLISTIC COMPETITION
The market structure of monopolistic competition has characteristics of both pure
monopoly and pure competition hence its name, but it is much closer to the market
structure of pure competition than pure monopoly. The characteristics of a monopolistic
competition market structure follow.
      1). large number or “many” sellers in market (not many, many as in pure
             competition),
       2). each firm has “limited control” over price of its product,
       3). limited barriers to entry so market entry and exit are relatively easy,
        4). non-price competition is prevalent
                 - firms compete with each by differentiating their product rather than thru
                    price changes. Methods of product differentiation include: different physical
                    features, better quality, customer service, advertising, financing
                    arrangements and brand loyalty.
        5). economic profits possible in short run, but zero economic profits in long run
               (breakeven).
         6). profit maximization (loss minimization): MR = MC (not equal to price).

MONOPOLISTIC COMPETITION VS PURE COMPETITION AND PURE MONOPOLY
Monopolistic competitive markets and firms are similar to those in pure competition
because in the short run, economic profits are possible; but in the long run economic
profits are not possible due to ease of entry. In contrast to pure competition, a
monopolistic competitive firm's demand curve is downward sloping and its marginal
revenue curve is below the demand curve (like monopoly). And like other market
structures, a firm maximizes profits (or minimizes losses) where MR = MC. Unlike pure
competition, however, price will not = MR because of the firm's downward sloping
demand curve.

Many markets in the economy are monopolistic competitive, such as gasoline stations,
convenience stores, restaurants, etc. Note that output in this market structure does not
achieve productive or allocative efficiency because minimum ATC is not achieved in the
long run and price always exceeds MC at profit max. This results in excess capacity for
firms in a monopolistic competitive market structure.

MECHANICS OF MONOPOLISTIC MARKET OPERATIONS

1). The demand curve for the firm is downward sloping to the right. This demand curve
         is less elastic (steeper-more inelastic) than in pure competition, but more elastic
        (flatter) than in perfect monopoly. The more inelastic the demand curve, the more
        market or monopoly power (ability to raise price) a firm has.

2). Firm’s MR curve lies below the firm’s demand curve.

3). Profits are maximized at the output where MR = MC.

4). Economic profits are possible (not guaranteed) in the short run, but in the long run
         firms will enter causing demand to drop for each firm and lowering prices thus
        eliminating any economic profits.

5). The long run equilibrium is breakeven (Price = ATC). Note that the breakeven here
          is at an output lower, price higher and ATC (per unit cost) higher than pure
          competition. The amount by which output is less than the “minimum ATC”
        represents “excess capacity” that exists at each firm. Although monopolistic firms
         only earn a normal profit in the long run they are considered inefficient because
          they are producing at a ATC higher than minimum ATC.

6). Firms will attempt to earn economic profit by trying to shift demand upward by
       differentiating or developing new products and advertising. Firms can also realize
       economic profits by reducing costs.