Monopolistic competition

Group 1

CONTENTS

First approach

Ice Cream

Advertising pros and cons

Price and output decisions

Short run

Long run

THEORY

Monopolistic competition is defined as a market structure characterized by:

- A large number of firms,

- Products which are differentiated and not seen as perfect

substitutes by consumers,

- Some ability of sellers to set prices as they wish,

- Free entry to and exit from the market,

- Heavy reliance on non-price actions to differentiate one's

product.

NUMBER OF FIRMS

The large number of firms in monopolistic competition implies

that the firms are small in comparison to the entire market.

Although they have some power over price (to the extent that

their products are differentiated), they do not have sufficient

power to retaliate if another firm changes its price. This is

the major distinction between this market form and oligopoly

DIFFERENTIATED PRODUCT

The differentiated product sold by a firm in monopolistic

competition has some features that makes a customer prefer it

over the available similar products of other firms. The features

may be physical or created by advertising. The power of any firm over price stems from

this very fact that products are not perfect substitutes. Non-price actions are necessary

to make the products differentiated.

ENTRY TO MARKET

No barriers to entry or exit exist in monopolistic competition.

However, the need to make one's product differentiated may

require non-price action, which, if unsuccessful, would drive

the firm out of the market.

DEMAND

The demand of a firm in monopolistic competition is down sloping because of the

preference of customers for the features of the differentiated product. However, because

there are many close (if not perfect) substitutes readily available, the demand is highly

elastic. Graphically, this means that the demand in monopolistic competition is flatter

than in monopoly.

PROFIT

The profit of a firm in monopolistic competition is determined

in the same fashion as in any other type of market by finding the optimum quantity

where marginal revenue intersects marginal cost. This optimum level of output, in turn,

determines the price charged (on the demand curve) and average unit cost (on the

average total cost curve). The profit is the excess of total revenue area over total cost

area.

LONG RUN EQUILIBRIUM

The long run equilibrium of a firm in

monopolistic competition is where demand is

tangent to the average total cost curve. There

is no profit. Should there be a profit (if

demand is above the average total cost curve),

firms would enter the market and drive the

demand down. And should there be a loss

(when demand is below average total cost),

firms would leave the market and push

demand up. Firms may, however, retain some

profits by using more non-price action.

ECONOMIC EFFECT

The economic effect of monopolistic competition is an overall

undesirable loss of allocative and productive efficiency: the

customer pays more and is able to buy less than in perfect

competition. However, the effect is not as serious as in

monopoly and the differentiated products provide a much sought diversity.

Nevertheless, some waste is present in excess

capacity and in use of non price competition.

NON-PRICE ACTION

Non price action of firms in monopolistic competition consists

primarily in either:

- Product development.

- Advertising.

Product development is sometimes only cosmetic to give the

illusion of novelty. Another danger stems from excessive

diversity which may confuse consumers.

ADVERTISING - ARGUMENTS IN

FAVOR

Some of the arguments in favor of advertising are

- advertising is informative,

- advertising increases sales and permits economies of scale,

- advertising increases sales and contributes to economic

growth,

- advertising supports the media,

- advertising increases competition and lowers prices.

ADVERTISING - ARGUMENTS AGAINST

Some of the arguments against advertising are

- Advertising is not informative but competitive,

- The economies of scale are illusory,

- Advertising raises the cost curve,

- Advertisers may use their influence to bias the media,

- Advertising is used as an entry barrier, and

- Advertising is not a productive activity.

Many small sellers

The very large number of small firms in monopolistic competition.

Collection of similar products.

The freedom to set prices without engaging in strategic decision.

Firm's actions have a negligible impact on the market.

Many factors affect Monopolistic Competition market structure support at market

equilibrium.

Haagen-Daz

Premium ice cream -> Earned considerably

economic profit.

The market started to be crowded.