ECONOMIC ANALYSIS

Lesson 23. MONOPOLISTIC COMPETITION

Module 5. Concepts of market

Lesson 23

MONOPOLISTIC COMPETITION

23.1 Introduction

Monopolistic competition occurs when a large number of sellers produce differentiated products. This market structure resembles perfect competition in that there are many sellers, none of whom have a large share of the market. It differs from perfect competition in that the products sold by different firms are not identical. Differentiated products are ones whose important characteristics. Personal computers, for example, have differing characteristics such as speed, memory, hard disk, modem, size, and weight. Because computers are differentiated, they can sell at slightly different prices.

The classic case of monopolistic competition is the retail petrol market. You may go to the local Indian oil petrol pump, even though it charges slightly more, because it is on your way to work. But if the price at Indian oil raises more than a few rupees above the competition, you might switch to the Bhart oil station a short distance away. This example illustrates the importance of location in product differentiation. It takes time to go to the bank or the grocery store, and the amount of time needed to reach different stores will affect our shopping choices. The whole price of a good includes not just its price but also the opportunity cost of search, travel time, and other non-price costs. Because prices of local goods are lower than those in faraway places, people generally tend to shop close to home or to work. This consideration also explains why large shopping complexes are so popular: they allow people to buy a wide variety of goods while economizing on shopping time. Today, shopping on the Internet is increasingly important because, even when shipping costs are added, the time required to buy the good online can be very low compared to getting in your car or walking to a shop. Product quality is an increasingly important part of product differentiation today. Goods differ in their characteristics as well as their prices. Most personal computers can run the same software, and there are many manufactures. Yet the personal computer industry is a monopolistically competitive industry, because computers differ in speed, size, memory, repair services, and ancillaries like CDs, DVDs, Internet connections, and sound systems. Indeed, a whole batch of monopolistically competitive computer magazines is devoted to explaining the differences among the computers produced by the monopolistically competitive computer manufactures.

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.

Competition among the few introduces a completely new feature into economic life: It forces firms to take into account competitors’ reactions to price and output derivations and brings strategic considerations into their markets.