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Monopolistic competition
From Wikipedia, the free encyclopedia

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit

Monopolistic competition is a form of imperfect competition where many competing producers sell products that are differentiated from one another (that is, the products are substitutes but, because of differences such as branding, not exactly alike). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.[1] In a monopolistically competitive market, firms can behave like monopolies in the short run, including by using market power to generate profit. In the long run, however, other firms enter the market and the benefits of differentiation decrease with competition; the market becomes more like a perfectly competitive one where firms cannot gain economic profit. In practice, however, if consumer rationality/innovativeness is low and heuristics are preferred, monopolistic competition can fall into natural monopoly, even in the complete absence of government intervention.[2] In the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933).[3] Joan Robinson is also credited as an early pioneer of the concept. Monopolistically competitive markets have the following characteristics:

There are many producers and many consumers in the market, and no business has total control over the market price. Consumers perceive that there are non-price differences among the competitors' products. There are few barriers to entry and exit.[4] Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost the same as a perfectly competitive market. Two differences between the two are that monopolistic competition produces heterogeneous products and monopolistic competition involves a great deal of non-price competition, which is based on subtle product differentiation. A firm making profits in the short run will nonetheless only break even in the long run because demand will decrease and average total cost will increase. This means in the long run, a monopolistically competitive firm will make zero economic profit. This illustrates the amount of influence the firm has over the market; because of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm's demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

Contents
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1 Major characteristics 2 Product differentiation 3 Many firms 4 Free entry and exit

5 Independent decision making 6 Market power 7 Perfect information 8 Inefficiency 9 Problems 10 Examples 11 Notes 12 See also 13 External links

[edit] Major characteristics


There are six characteristics of monopolistic competition (MC):

Product differentiation Many firms Free entry and exit in the long run Independent decision making Market Power Buyers and Sellers have perfect information[5][6]

[edit] Product differentiation


MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of demand between goods in such a market is positive. In fact, the XED would be high.[7] MC goods are best described as close but imperfect substitutes.[7] The goods perform the same basic functions but have differences in qualities such as type, style, quality, reputation, appearance, and location that tend to distinguish them from each other. For example, the basic function of motor vehicles is basically the same - to move people and objects from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles such as motor scooters, motor cycles, trucks, cars and SUVs and many variations even within these categories.

[edit] Many firms


There are many firms in each MC product group and many firms on the side lines prepared to enter the market. A product group is a "collection of similar products".[8] The fact that there are "many firms" gives each MC firm the freedom to set prices without engaging in strategic decision making regarding the prices of other firms and each firm's actions have a negligible impact on the market. For example, a firm could cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors.

How many firms will an MC market structure support at market equilibrium? The answer depends on factors such as fixed costs, economies of scale and the degree of product differentiation. For example, the higher the fixed costs, the fewer firms the market will support.[9] Also the greater the degree of product differentiation - the more the firm can separate itself from the pack - the fewer firms there will be at market equilibrium.

[edit] Free entry and exit


In the long run there is free entry and exit. There are numerous firms waiting to enter the market each with its own "unique" product or in pursuit of positive profits and any firm unable to cover its costs can leave the market without incurring liquidation costs. This assumption implies that there are low start up costs, no sunk costs and no exit costs.

[edit] Independent decision making


Each MC firm independently sets the terms of exchange for its product.[10] The firm gives no consideration to what effect its decision may have on competitors.[10] The theory is that any action will have such a negligible effect on the overall market demand that an MC firm can act without fear of prompting heightened competition. In other words each firm feels free to set prices as if it were a monopoly rather than an oligopoly.

[edit] Market power


MC firms have some degree of market power. Market power means that the firm has control over the terms and conditions of exchange. An MC firm can raise it prices without losing all its customers. The firm can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC firm's market power is not barriers to entry since they are low. Rather, an MC firm has market power because it has relatively few competitors, those competitors do not engage in strategic decision making and the firms sells differentiated product.[11] Market power also means that an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although not "flat".

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Monopolistic Competition

Price and Output Determination in Monopolistic Competition

Monopolistically competitive industries are made up of a large number of firms, each small relative to the size of the total market. Thus, no one firm can affect market price by virtue of its size alone. But firms differentiate their products, and by so doing gain some control over price.

Product Differentiation and Demand Elasticity


Perfectly competitive firms face a perfectly elastic demand curve for their product because all firms in their industry produce the exact same product. A monopolistic competitor faces a downward-sloping firm demand curve. This type of curve is based on the notion that the firm can change its price without losing all of its business because buyers do not see any perfect substitute. The fewer the substitutes (i.e., the more product differentiation), the less elastic the demand curve will be. The difference is illustrated in the figure below:

A monopolistic competitor, in the short run, is like a monopolist because it is the only producer of its unique product. But unlike a monopoly, the monopolistically competitive firm faces competition from other firms producing good substitutes for its product.

Price/Output Determination in the Short Run


Since the firm has a downward-sloping demand curve, it will also have a downward-sloping marginal revenue (MR) curve. A profit-maximizing firm produces where marginal cost (MC) equals marginal revenue (q0 in the graph below) and charges the price determined by demand (P0).

In panel (a) of the figure, the monopolistic competitor will make a profit. However, like a monopoly, a monopolistic competitor is not guaranteed to make a profit in the short run. The firm may make a loss in the short run; its profitability will depend on the demand. This is shown in panel (b). To more fully understand price and output determination in monopolistic competition, try the following Active Graph exercise:

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