Microeconomics Notes Monopolistic Competition

Monopolistic Competition: Assumptions of the model: 1. There are many firms, each of which acts independently of the others. 2. There is freedom of entry and exit in the industry; there are no or low barriers to entry. 3. Product differentiation occurs when each firm tries to make its product different from others. Products can be differentiated by appearance, taste, color, size, quality, branding, services (such as warrantees), and location (easy access by consumers). Product differentiation forms the basis of non-price competition. Examples of firms with monopolistic competition are cafes, hairdressers, and furniture shops. Product Differentiation, non-price competition, and the shape of the demand curve: Product differentiation is crucially important as firms use it to create monopoly power. The more consumers can be convinced of a product’s superiority over its substitutes produced by rival firms, the greater the firm's monopoly power. Therefore, the firm in monopolistic competition faces a downward-sloping demand curve, less elastic than in perfect competition yet more elastic than in monopoly, where price and quantity demanded are inversely related. Price competition: Competition between firms to attract customers away from the products of other producers by lowering the price of their products. Nonprice competition: Competition between firms to attract customers based on factors other than price through product differentiation. Monopolistically competitive firms use both price and non-price competition. Generally, the more successful the non-price competition, the greater the monopoly power, the less elastic the demand curve, and the lower the reliance on price competition. Profit maximization and loss minimization in the short run: Same as in Monopoly: Normal Profits in the long run: Due to low barriers to entry, forms earn normal profits in the long run. New firms are attracted to the industry when they earn abnormal profits and capture part of the market share of existing firms. Therefore, the D curve for existing firms shifts left until it is tangent to the AC curve, so P = AC. Existing firms leave the industry when they are earning losses, and the existing firms capture part of the market share of the exited firms. Therefore, the D curve for the remaining firms shifts right until it is tangent to AC, so P = AC. Criticisms of the model: 1. The diagrams suggest that profit maximization involves firm decisions regarding price and quantity, whereas, in fact, an important part of firm activity involves decisions regarding product differentiation. 2. Product differentiation and the presence of, in effect, many monopolies do not allow analysis at the industry level, as it is impossible to add up demand curves. 3. In reality, there can be higher barriers to entry than the model assumes. 4. Product differentiation presupposes research and development, but a lack of abnormal profits in the long run suggests this is impossible. Yet firms in monopolistic competition still carry out some research and development. Comparison of monopolistic competition with other market structures: Monopolistic competition and Perfect competition: Similarities: 1. A large number of firms. 2. No barriers to entry. 3. Normal Profit in the long run. Differences: 1. Market power and the demand curve. 2. Allocative efficiency. 3. Product variety. 4. Economies of scale. Monopolistic Competition and Monopoly: Similarities: 1. No allocative efficiency is a form of market failure. Differences: 1. Number of producers. 2. Size of firms (small in monopolistic). 3. Barriers to entry. 4. Normal and abnormal profits (LR SR). 5. Competition and Prices. 6. Market power (Higher in monopoly because there are no substitutes). 7. Competition and costs (lower in Monopolistic competition due to downward pressure on costs). 8. Research and development (abnormal profits in the long run for monopoly). 9. Economies of scale and possibility of natural monopoly (Monopolistically competitive firms can only achieve limited EOS; in cases like natural monopoly, the high EOS makes the monopoly more desirable for society). 10. Product variety (monopolies produce different products, but they are much more varied in monopolistic competition due to product differentiation).