Lesson 23. MONOPOLISTIC COMPETITION
23.2 Monopolistic Competition
Monopolistic competition resembles perfect competition in three ways: there are many buyers and sellers entry and exit are easy, and firms take other firms prices as given. The distinction is that products are identical under perfect competition, while under monopolistic competition they are differentiated.
Monopolistic competition is very common – just scan the shelves at any supermarket and you’ll see a dizzying array of different brands of breakfast cereals, shampoos and frozen foods. Within each product group, products or services are different, but close enough to complete with each other. Here are some other examples of monopolistic competition: there may be several grocery stores in a neighborhood, each carrying the same goods but at different locations. Gas stations, too all see the same products, but they complete on the basis of location and brand name. The several hundred magazines on a newsstand rack are monopolistic competitors, as are the 50 or so completing brand of personal computers. The list is endless.
The important point is that product differentiation means each seller has some freedom to raise or lower prices, more so than in a perfectly competitive market. Product differentiation leads to a downward slope in each seller’s demand curve.
Fig. 23.1 Monopolistic competitors produce many similar goods
Figure might represent a monopolistically competitive fishing magazine which is in short-run equilibrium at G. the firm’s dd demand curve shows the relationship between sales and its price when other magazine prices are unchanged; its demand curve slopes downward since this magazine is a little different from everyone else’s because of its special focus. The profit-maximizing price is at G. because price at G is above average cost; the firm is making a handsome profit represented by area ABGC.
But our magazine has no monopoly on writers or news print or insights on fishing. Firms can enter the industry by hiring editor, having a bright new idea and logo, locating the printer, and hiring workers. Since the fishing magazine industry is profitable, entrepreneurs bring new fishing magazine into the market. With their introduction, the demand curve for the products of existing monopolistically competitive fishing magazine shifts leftwards as the new magazines nibble away at our magazine’s market.
The ultimate outcome is that fishing magazines will continue to enter the market until all economic profits (including the appropriate opportunity costs for owners’ time, talent, and contributed capital) have been beaten down to zero. Figure 2 shows the final long-run equilibrium for the typical seller. In equilibrium, the demand is reduced or shifted to the left until the new d’d’ demand curve just touches (but never goes above) the firm’s AC curve. Point G’ is a long-run equilibrium for the industry because profits are zero and no one is tempted to enter or forced to exit the industry.
The monopolistic competition model provides an important insight into American capitalism: the rate of profit will in the long run be zero in this kind of imperfectly competitive as firms enter with new differentiated products.In the long-run equilibrium for monopolistic competition, prices are above marginal costs but economic profits have been driven down to zero.
Some critics believe that monopolistic competition is inherently inefficient, even through profits are zero in the long run. They argue that monopolistic competition breeds an excessive number of new products and that eliminating unnecessary product differentiation could really cut costs and lower prices. To understand their reasoning, look back at the long-run equilibrium price at G’ in fig 2. At that point, price is above marginal cost; hence, output is reduced below the ideal competitive level.
Fig. 23.2 Free entry of numerous monopolistic competitors wipes out profits
The economic critique of monopolistic competition has considerable appeal. It takes real ingenuity to demonstrate the gains of human welfare. The great variety of goods and services produced by a modern market economy, reducing the number of monopolistic competitors, while cutting costs, might well end up lowering consumer well end up lowering consumer welfare because it would reduce the diversity of available products. Centrally planned socialist countries tried to standardize output to a small number of goods but their consumers became highly dissatisfied when they looked at the variety available in the market economics. People will pay a premium to be free to choose.
In imperfect competition, we turn back to markets in which only a few firms compete. Instead of focusing on collusion, consider the fascinating with each other. Strategic interaction is found in any market which has relatively few competitors. Like tennis player trying to outguess her opponent, each business musk ask how its rivals will react to changes in key model of refrigerator, what will Whirlpool, its principal rival, do? If America Airlines lowers its transcontinental fares, how will United react?
Consider as an example the market for air shuttle service between New York and Washington, currently served by Delta and US Airways. This market is called the duopoly because it is served by two firms. Similar strategic interactions are found in many large industries: in television, in automobiles, even in economics textbooks. Unlike the simple approaches of monopoly and perfect competition, it turns out that there is no simple theory to explain how oligopolists behave. Different cost and demand structures, different industries, even different temperaments on the part of the firms’ managers will lead to different strategic interactions and to different pricing strategies. Sometimes, the best behaviour is to introduce some randomness into the response simply to keep the opposition off balance.