Although the process by which a monopolistic competitor makes decisions about quantity and price is similar to the way in which a monopolist makes such decisions, two differences are worth remembering. Second, a monopolist is surrounded by barriers to entry and need not fear entry, but a monopolistic competitor who earns profits must expect the entry of firms with similar, but differentiated, products.
If one monopolistic competitor earns positive economic profits, other firms will be tempted to enter the market. A gas station with a great location must worry that other gas stations might open across the street or down the road—and perhaps the new gas stations will sell coffee or have a carwash or some other attraction to lure customers. A successful restaurant with a unique barbecue sauce must be concerned that other restaurants will try to copy the sauce or offer their own unique recipes.
A laundry detergent with a great reputation for quality must be concerned that other competitors may seek to build their own reputations. The entry of other firms into the same general market like gas, restaurants, or detergent shifts the demand curve faced by a monopolistically competitive firm.
The shift in marginal revenue will change the profit-maximizing quantity that the firm chooses to produce, since marginal revenue will then equal marginal cost at a lower quantity. Figure 3 a shows a situation in which a monopolistic competitor was earning a profit with its original perceived demand curve D 0. The intersection of the marginal revenue curve MR 0 and marginal cost curve MC occurs at point S, corresponding to quantity Q 0 , which is associated on the demand curve at point T with price P 0.
The combination of price P 0 and quantity Q 0 lies above the average cost curve, which shows that the firm is earning positive economic profits. Unlike a monopoly, with its high barriers to entry, a monopolistically competitive firm with positive economic profits will attract competition.
Moving vertically up from that quantity on the new demand curve, the optimal price is at P 1. When price is equal to average cost, economic profits are zero. Thus, although a monopolistically competitive firm may earn positive economic profits in the short term, the process of new entry will drive down economic profits to zero in the long run. Remember that zero economic profit is not equivalent to zero accounting profit.
Figure 3 b shows the reverse situation, where a monopolistically competitive firm is originally losing money.
The adjustment to long-run equilibrium is analogous to the previous example. The economic losses lead to firms exiting, which will result in increased demand for this particular firm, and consequently lower losses.
Firms exit up to the point where there are no more losses in this market, for example when the demand curve touches the average cost curve, as in point Z. Monopolistic competitors can make an economic profit or loss in the short run, but in the long run, entry and exit will drive these firms toward a zero economic profit outcome.
However, the zero economic profit outcome in monopolistic competition looks different from the zero economic profit outcome in perfect competition in several ways relating both to efficiency and to variety in the market.
The long-term result of entry and exit in a perfectly competitive market is that all firms end up selling at the price level determined by the lowest point on the average cost curve. This outcome is why perfect competition displays productive efficiency : goods are being produced at the lowest possible average cost.
However, in monopolistic competition, the end result of entry and exit is that firms end up with a price that lies on the downward-sloping portion of the average cost curve, not at the very bottom of the AC curve. Thus, monopolistic competition will not be productively efficient. In a perfectly competitive market, each firm produces at a quantity where price is set equal to marginal cost, both in the short run and in the long run.
This outcome is why perfect competition displays allocative efficiency: the social benefits of additional production, as measured by the marginal benefit, which is the same as the price, equal the marginal costs to society of that production. A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units.
This is the same argument we made about monopoly, but in this case to a lesser degree. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry.
See the following Clear It Up feature for more detail on the impact of demand shifts. This information on total revenue is then used to calculate marginal revenue, which is the change in total revenue divided by the change in quantity. A change in perceived demand will change total revenue at every quantity of output and in turn, the change in total revenue will shift marginal revenue at each quantity of output.
Thus, when entry occurs in a monopolistically competitive industry, the perceived demand curve for each firm will shift to the left, because a smaller quantity will be demanded at any given price. Another way of interpreting this shift in demand is to notice that, for each quantity sold, a lower price will be charged. Consequently, the marginal revenue will be lower for each quantity sold—and the marginal revenue curve will shift to the left as well. Conversely, exit causes the perceived demand curve for a monopolistically competitive firm to shift to the right and the corresponding marginal revenue curve to shift right, too.
A monopolistically competitive industry does not display productive and allocative efficiency in either the short run, when firms are making economic profits and losses, nor in the long run, when firms are earning zero profits. Even though monopolistic competition does not provide productive efficiency or allocative efficiency, it does have benefits of its own.
Product differentiation is based on variety and innovation. Many people would prefer to live in an economy with many kinds of clothes, foods, and car styles; not in a world of perfect competition where everyone will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and drive an identical model of car.
Many people would prefer to live in an economy where firms are struggling to figure out ways of attracting customers by methods like friendlier service, free delivery, guarantees of quality, variations on existing products, and a better shopping experience.
Economists have struggled, with only partial success, to address the question of whether a market-oriented economy produces the optimal amount of variety. Critics of market-oriented economies argue that society does not really need dozens of different athletic shoes or breakfast cereals or automobiles. Another key difference between the two is product differentiation. In a perfectly competitive market products are perfect substitutes for each other. But in monopolistically competitive markets the products are highly differentiated.
A final difference involves barriers to entry and exit. In a monopolistic competitive market there are few barriers to entry and exit, but still more than in a perfectly competitive market. In terms of economic efficiency, firms that are in monopolistically competitive markets behave similarly as monopolistic firms.
This quantity is less than what would be produced in a perfectly competitive market. It also means that producers will supply goods below their manufacturing capacity. Firms in a monopolistically competitive market are price setters, meaning they get to unilaterally charge whatever they want for their goods without being influenced by market forces. In these types of markets, the price that will maximize their profit is set where the profit maximizing production level falls on the demand curve.
This means two things:. Regardless of whether there is a decline in producer surplus, the loss in consumer surplus due to monopolistic competition guarantees deadweight loss and an overall loss in economic surplus. Productive efficiency occurs when a market is using all of its resources efficiently. In a monopolistic competitive market, firms always set the price greater than their marginal costs, which means the market can never be productively efficient.
Allocative efficiency occurs when a good is produced at a level that maximizes social welfare. Advertising and branding help firms in monopolistic competitive markets differentiate their products from those of their competitors. One of the characteristics of a monopolistic competitive market is that each firm must differentiate its products.
Two ways to do this is through advertising and cultivating a brand. Advertising is a form of communication meant to inform, educate, and influence potential customers about products and services.
Advertising is generally used by businesses to cultivate a brand. Listerine advertisement, : From until the mids, Listerine was also marketed as preventive and a remedy for colds and sore throats.
The purpose of the brand is to generate an immediate positive reaction from consumers when they see a product or service being sold under a certain name in order to increase sales. Reputation among consumers is important to a monopolistically competitive firm because it is arguably the best way to differentiate itself from its competitors. However, for that reputation to be maintained, the firm must ensure that the products associated with the brand name are of the highest quality.
This standard of quality must be maintained at all times because it only takes one bad experience to ruin the value of the brand for a segment of consumers. Brands and advertising can thus help guarantee quality products for consumers and society at large. Advertising is also valuable to society because it helps inform consumers. Markets work best when consumers are well informed, and advertising provides that information.
Finally, advertising allows new firms to enter into a market. Consumers might be hesitant to purchase products with which they are unfamiliar. Advertising can educate and inform those consumers, making them comfortable enough to give those products a try.
There are some concerns about how advertising can harm consumers and society as well. Some believe that advertising and branding induces customers to spend more on products because of the name associated with them rather than because of rational factors. Further, there is no guarantee that advertisements accurately describe products; they can mislead consumers. Privacy Policy. Skip to main content. Monopolistic Competition. Search for:.
Defining Monopolistic Competition Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another. Learning Objectives Evaluate the characteristics and outcomes of markets with imperfect competition.
Key Takeaways Key Points Monopolistic competition is different from a monopoly. First, at its optimum output the firm charges a price that exceeds marginal costs.
Monopolistic competitive markets have highly differentiated products; have many firms providing the good or service; firms can freely enter and exits in the long-run; firms can make decisions independently; there is some degree of market power; and buyers and sellers have imperfect information. Key Terms monopoly : A market where one company is the sole supplier.
Monopolistic competition : A type of imperfect competition such that one or two producers sell products that are differentiated from one another as goods but not perfect substitutes such as from branding, quality, or location.
Product Differentiation Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market.
Learning Objectives Define product differentiation. Key Takeaways Key Points Differentiation occurs because buyers perceive a difference between products. This outcome is why perfect competition displays allocative efficiency: the social benefits of additional production, as measured by the marginal benefit, which is the same as the price, equal the marginal costs to society of that production.
A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units. This is the same argument we made about monopoly, but in this case the allocative inefficiency will be smaller. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry.
See the following Clear It Up feature for more detail on the impact of demand shifts. We then use this information on total revenue to calculate marginal revenue, which is the change in total revenue divided by the change in quantity.
A change in perceived demand will change total revenue at every quantity of output and in turn, the change in total revenue will shift marginal revenue at each quantity of output. Thus, when entry occurs in a monopolistically competitive industry, the perceived demand curve for each firm will shift to the left, because a smaller quantity will be demanded at any given price.
Another way of interpreting this shift in demand is to notice that, for each quantity sold, the firm will charge a lower price. Consequently, the marginal revenue will be lower for each quantity sold—and the marginal revenue curve will shift to the left as well.
Conversely, exit causes the perceived demand curve for a monopolistically competitive firm to shift to the right and the corresponding marginal revenue curve to shift right, too.
A monopolistically competitive industry does not display productive or allocative efficiency in either the short run, when firms are making economic profits and losses, nor in the long run, when firms are earning zero profits.
Even though monopolistic competition does not provide productive efficiency or allocative efficiency, it does have benefits of its own.
Product differentiation is based on variety and innovation. Most people would prefer to live in an economy with many kinds of clothes, foods, and car styles; not in a world of perfect competition where everyone will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and drive an identical model of car. Most people would prefer to live in an economy where firms are struggling to figure out ways of attracting customers by methods like friendlier service, free delivery, guarantees of quality, variations on existing products, and a better shopping experience.
Economists have struggled, with only partial success, to address the question of whether a market-oriented economy produces the optimal amount of variety. Critics of market-oriented economies argue that society does not really need dozens of different athletic shoes or breakfast cereals or automobiles. They argue that much of the cost of creating such a high degree of product differentiation, and then of advertising and marketing this differentiation, is socially wasteful—that is, most people would be just as happy with a smaller range of differentiated products produced and sold at a lower price.
Defenders of a market-oriented economy respond that if people do not want to buy differentiated products or highly advertised brand names, no one is forcing them to do so. Moreover, they argue that consumers benefit substantially when firms seek short-term profits by providing differentiated products. This controversy may never be fully resolved, in part because deciding on the optimal amount of variety is very difficult, and in part because the two sides often place different values on what variety means for consumers.
Read the following Clear It Up feature for a discussion on the role that advertising plays in monopolistic competition. Roughly one third of this was television advertising, and another third was divided roughly equally between internet, newspapers, and radio.
The remaining third was divided between direct mail, magazines, telephone directory yellow pages, and billboards. Mobile devices are increasing the opportunities for advertisers.
In either case, a successful advertising campaign may allow a firm to sell either a greater quantity or to charge a higher price, or both, and thus increase its profits. However, economists and business owners have also long suspected that much of the advertising may only offset other advertising. Economist A. Pigou wrote the following back in in his book, The Economics of Welfare :. It may happen that expenditures on advertisement made by competing monopolists [that is, what we now call monopolistic competitors] will simply neutralise one another, and leave the industrial position exactly as it would have been if neither had expended anything.
For, clearly, if each of two rivals makes equal efforts to attract the favour of the public away from the other, the total result is the same as it would have been if neither had made any effort at all. Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the firm sells the product, intangible aspects of the product, and perceptions of the product.
The perceived demand curve for a monopolistically competitive firm is downward-sloping, which shows that it is a price maker and chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist, because the monopolistic competitor has direct competition, unlike the pure monopolist.
A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost. If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will experience exit of firms until economic losses are driven up to zero in the long run.
A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive firm. Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services.
There is some controversy over whether a market-oriented economy generates too much variety. Suppose that, due to a successful advertising campaign, a monopolistic competitor experiences an increase in demand for its product.
In total, the researchers looked at consumer product markets using the Herfindahl-Hirschman Index—a standard measure of the size of companies relative to the industry they operate in—to assess concentration at the market and product levels over time. Industries with HHIs between 1, and 2, are considered moderately concentrated, with anything above 2, being highly concentrated.
The researchers hypothesize that this effect could be driven by economies of scale and greater efficiencies in processes and operations as large companies consolidate their presence and integrate expertise and know-how from the smaller firms they acquire. Superior access to research and development and emerging technologies may also have a role to play in streamlining production and manufacturing—a benefit that seems to be making its way across conglomerates and their roster of owned brands and into the pockets of US consumers.
This has implications for US legislators concerned about rising concentration. To date, the understanding of the full dynamics at play within the US antitrust context has been incomplete, the researchers argue.
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