Monopolistic competition is a market structure characterized by a large number of relatively small firms. While the goods produced by the firms in the industry are similar, slight differences often exist. As such, firms operating in monopolistic competition are extremely competitive but each has a small degree of market control. In effect, monopolistic competition is something of a hybrid between perfect competition and monopoly. Comparable to perfect competition, monopolistic competition contains a large number of extremely competitive firms. However, comparable to monopoly, each firm has market control and faces a negatively-sloped demand curve',500,400)">demand curve. The real world is widely populated by monopolistic competition. Perhaps half of the economy's total production comes from monopolistically competitive firms. The best examples of monopolistic competition come from retail trade, including restaurants, clothing stores, and convenience stores.
The four characteristics of monopolistic competition are: (1) large number of small firms, (2) similar, but not identical products, (3) relatively good, but not perfect resource mobility, and (4) extensive, but not perfect knowledge. Large Number of Small Firms: A monopolistically competitive industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that all firms are relatively competitive with very little market control over price or quantity. In particular, each firm has hundreds or even thousands of potential competitors. Similar Products: Each firm in a monopolistically competitive market sells a similar, but not absolutely identical, product. The goods sold by the firms are close substitutes for one another, just not perfect substitutes. Most important, each good satisfies the same basic want or need. The goods might have subtle but actual physical differences or they might only be perceived different by the buyers. Whatever the reason, buyers treat the goods as similar, but different. Relative Resource Mobility: Monopolistically competitive firms are relatively free to enter and exit an industry. There might be a few restrictions, but not many. These firms are not "perfectly" mobile as with perfect competition, but they are largely unrestricted by government rules and regulations, start-up cost, or other substantial barriers to entry. Extensive Knowledge: In monopolistic competition, buyers do not know everything, but they have relatively complete information about alternative prices. They also have relatively complete information
One good uses plastic.
Demand and Revenue
The four characteristics of monopolistic competition mean that a monopolistically competitive firm faces a relatively elastic. unlike perfect competition." while another provides express checkout. but not perfect substitutes. demand curve. However. In the exhibit to the right. The goods are essentially the same. the other is vanilla. products that are physically identical and perceived to be identical are differentiated by support services. the quantity demanded drops to zero. One good is chocolate. Even though the products purchased are identical. and (3) support services. the other aluminum.50. brand names. where the only difference is the packaging. demand is not perfectly elastic (as in perfect competition) because the output of each firm is slightly different from that of other firms. but they have slight differences. etc. a monopolistically competitive firm has the ability to raise or lower
. Support Services: In still other cases. one retail store might offer "service with a smile. Such differences are often created by brand names. such as the one displayed in the exhibit to the right. Monopolistically competitive goods are close substitutes.50. Each seller also has relatively complete information about production techniques and the prices charged by their competitors. Each firm in a monopolistically competitive market can sell a wide range of output within a relatively narrow range of prices. very close substitutes. but not perfectly elastic. (2) perceived differences.Product differentiation is the primary reason that each firm operating in a monopolistically competitive market is able to create a little monopoly all to itself. Once again. Perceived Differences: In other cases goods are only perceived to be different by the buyers. even though no physical differences exist. Physical Differences: In some cases the product of one firm is physically different form the product of other firms. with some degree of control over price. Should the price go higher than $6. A monopolistically competitive firm is a price maker.
Market Structure of Monopolistic Competition: Product Differentiation
The goods produced by firms operating in a monopolistically competitive market are subject to product differentiation. Demand is relatively elastic in monopolistic competition because each firm faces competition from a large number of very. Product differentiation is usually achieved in one of three ways: (1) physical differences.about product differences. the monopolistically competitive firm can sell up to 10 units of output within the range of $5.50 to $6.
Demand Curve.Monopolistic competition
The analysis of short-run production by a monopolistically competitive firm provides insight into market supply. or at the peak of the profit curve in the lower panel. cost conditions. And like monopoly. less than price. because demand is relatively elastic. The slightly curved green line is total revenue. The firm chooses to produce the quantity of output that generates the highest possible level of profit.80. but a little. the profit maximizing output quantity is 6. The marginal revenue for the fifth unit is $4. Any other level of production generates less profit. The difference between total revenue and total cost is profit. like any other firm. Because price depends on quantity. 5 units of output correspond to a $5 price. the total revenue curve is not a straight line. For example. The top panel indicates the two sides of the profit decision--revenue and cost. which is illustrated in the lower panel as the brown line. The key assumption is that a monopolistically competitive firm. production technology.
. the difference tends to be relatively small. The curved red line is total cost. the marginal revenue curve (MR) lies below the demand/average revenue curve (D = AR). but not by much. In this example. In the exhibit to the right.the price a little. is motivated by profit maximization. etc. not much. A firm maximizes profit by selecting the quantity of output that generates the greatest gap between the total revenue line and the total cost line in the upper panel. given price. the price received by a monopolistically competitive firm (which is also the firm's average revenue) is greater than its marginal revenue. While marginal revenue is less than price. market demand. The short-run production decision for monopolistic competition can be illustrated using the exhibit to the right.
Because a monopolistically competitive firm has some market control and faces a negatively-sloped demand curve. The second of the folds is the pursuit of profit maximization by each firm in the industry. with all inputs variable. At this level of output. a monopolistically competitive industry reaches equilibrium at an output that generates economies of scale or increasing returns to scale. This ensures that firms earn zero economic profit and that price is equal to average cost. the negatively-sloped demand curve is tangent to the negatively-sloped segment of the long run-average cost curve. The first of the folds is entry and exit of firms into and out of the industry.Monopolistic competition
In the long run.Short run production. This is achieved through a two-fold adjustment process. the end result of this long-run adjustment is two equilibrium conditions:
. This ensures that firms produce the quantity of output that equates marginal revenue with short-run and long-run marginal cost.
which is set equal to marginal cost when maximizing profit. a monopoly that charges a $100 price while incurring a marginal cost of $20 creates a serious inefficiency problem. The reason for this inefficiency is found with market control. In the grand scheme of economic problems. meaning no firm is inclined to enter or exit the industry. These conditions are satisfied separately. For example. Resources are NOT being used to generate the highest possible level of satisfaction. the price charged by a monopolistically competitive firm is greater than its marginal cost. This further means that monopolistic competition does NOT achieve long-run equilibrium at the minimum efficient scale of production.95 is substantially less. With price equal to average cost. and deservedly
Monopolistic competition in managerial decisions:
.MR = MC = LRMC P = AR = ATC = LRAC With marginal revenue equal to marginal cost.
Real World (In)Efficiency
A monopolistically competitive firm generally produces less output and charges a higher price than would be the case for a perfectly competitive industry. The closer marginal revenue is to price. the inefficiency created by a monopolistically competitive firm that charges a $50 price while incurring a marginal cost of $49. each firm is maximizing profit and has no reason to adjust the quantity of output or factory size. Economic profit is zero and there are no economic losses. However. the two equations are not equal (unlike perfect competition). because the demand curve is relatively elastic. While monopolistic competition is technically inefficient. Even though price is greater than marginal revenue (and thus marginal cost).. In contrast. each firm in the industry is earning only a normal profit.. it faces a negatively-sloped demand curve and price is greater than marginal revenue. the inefficiency created by monopolistic competition seldom warrants much attention. the closer a monopolistically competitive firm comes to allocating resources according to the efficiency benchmark established by perfect competition. In particular. it tends to be less inefficient than other market structures. Because a monopolistically competitive firm has control over a small slice of the market. The inequality of price and marginal cost violates the key condition for efficiency. because price is not equal to marginal revenue. the difference is often relatively small. especially monopoly.
In this case. Firms can also advertise a product that fills special needs in the market.
Optimal Advertising Decisions Optimal advertising is determined by the following formula Formula: The profit maximizing advertising-to-sales ratio. To keep the other consumers from switching to the substitutes. A = %ΔQ / %ΔA = (ΔQ / ΔA)*(A/Q) is advertising elasticity of demand. where firms such as McDonalds attempt to simulate demand for their hamburgers by differentiating them from competing brands. EQ. Comparative advertising is common in the fast–food industry. 1) Comparative Advertising: This involves campaigns designed to differentiate a given firm’s brand from brands sold by competing firms. There are two kinds of advertising under monopolistic competition. P)] > 0. The products could be totally “new” or “new improved”. firms under monopolistic competition spend a lot of money on advertising. the products are not perfect substitutes. A/R = [(EQ. The implication of this is that some consumer won’t switch when the prices go up within a limit. Note: A/R is a positive fraction because (EQ. P) is already negative and multiplied by a minus). The firm packages a product with materials that are recyclable. 2) Niche Marketing: Firms under monopolistic competition frequently introduce new products. and
. This additional value for a brand in the price is called brand equity.
where A is expenditure on advertising and R is sales revenue. This advertising strategy targets a special group of consumers. This may induce consumers to pay a premium for a particular brand.
These advertising strategies can bring positive profits in the short–run. In the long–run other firms will mimic their strategy and reduce profits to zero. monopolistically competitive firms differentiate their products in order to have some control over the price.(EQ. A) / . For example “green marketing” advertise “environmentally friendly” products to target the segment of the society that is concerned with the environment. and this makes the demand less than perfectly elastic.Implication of Product Differentiation: Advertising Decisions As mentioned above. while others are willing to switch.
That is. the higher the optimal advertising.tosales ratio.e. This is a case of more competition than less.
• If EQ. the optimal advertising-to-sales ratio is zero for the perfectly competitive firm. P = %ΔQ / %ΔP = (ΔQ / ΔP)*(P / Q).. and there is not much need for advertising. the lower the optimal advertising-to-sales ratio. is the own–price direct elasticity of demand.EQ. • The more elastic the demand with respect to advertising. products are less differentiated and more substitutable). then A/R = 0. which is negative.∞ (demand is perfectly price elastic under perfect competition). • The more elastic the demand with respect to own price (i.
. P = .