3.4.3 - Monopolistic competition

Question 1

Characteristics of monopolistic competition

Answer 1

• Many small buyers and sellers
• Slightly differentiated goods : This makes demand elastic.
• Some** price making power** due to Slightly differentiated products therefore firms can compete in non-price competition. (branding, advertising, quality)
• Low barriers to entry or exit : No economies of scale to bring down prices to anti-competitive prices, few patents, low sunk cost
• Short run profit maximisers
• Good information

Question 2

Examples of monopolistic competition

Answer 2

• Bars
• Restaurant
• Hairdressers

Question 3

How would monopolistic competition look in the short run on a diagram.

Answer 3

• Draw a firm making SNP
• Make your demand price elastic
• They produce at Q where MR=MC as we assume that firms are profit maximisers.
• Miss explain : Similar to the short run of a monopolist. Profit is maximised at MC=MR* (output Q1) (*same for all firms in all market structures) leading to an equilibrium price at P1. Supernormal profits are made because AR exceeds AC in the shaded area. (C1 AC).
  Although the diagram above shows supernormal profits, it is worth noting that in the SR a firm can make losses.

Question 4

How would monopolistic competition look in the long run on a diagram.

Answer 4

• Normal profits in the long run.
• This is due to good knowledge of profits being made and low barriers to entry.
• SNP: The entry of new firms will increase supply from S1 to S1 and the market price will fall from P1 to P2. This will cause the average revenue and MR curve(demand curve) to shift left until AR=AC ie. Until normal profit is made. This is because consumers have more choice of which firms to go to and so AR and MR will decrease for the firm making SNPs. Because normal profits are being mad potential suppliers have no reason to enter the market.
• SBP: If the firm was making a loss, it would leave
  the industry, reducing supply (S-S1) and shifting the AR curve upwards again to a point where AR=AC. Therefore, in the long run, a monopolistically competitive firm can make neither losses. (the same thing that happens in a perfectly competitive market)

Question 5

Are firms allocatively efficient in the long run ?

Answer 5

• Allocative efficiency is when P=MC
• No : firms are being allocatively inefficient as P>MC at output Q
• Explain : in the long run because they have some pricing power due to their differentiated products/services. They are unable to charge a lower price because of the high costs involved in producing a small amount of differentiated output. This could mean consumers are exploited as prices are greater than costs, output is restricted/choice is reduced.

Question 6

Are firms productively efficient in the long run ?

Answer 6

• Productive efficiency is when MC=AC
• No: Firms are being productively inefficient as it does not produce at the minimum point on the average cost curve for output Q therefore firms are voluntarily not taking advantage of all economies of scale.
• Explain : The product differentiation allows firms to charge higher prices and therefore produce at a lower output than the lowest point in the AC curve.

Question 7

Are firms x - efficient in the long run ?

Answer 7

• X-efficiency is when firms are minimising waste.
• Yes : Firms only make a normal profit even when X-efficient so there is no space for X-inefficiency.

Question 8

Are firms dynamically efficient in the long run ?

Answer 8

• Dynamic efficiency is when firms innovate new technology, and invest in R&D.
• No : There is no long run supernormal profit to reinvest.

Evaluation - However, the market power of firms comes from their differentiation, so there is still likely to be innovation.

Question 9

Blurt everything you know about Product differentiation

Answer 9

• firms compete is by making their products as distinctive as possible to increase consumer loyalty.
• This is through non-price competition.
• Firms do this in attempt to make their demand curve more inelastic which will help to increase their market power

Question 10

Advantages of monopolistic competition for consumers in a monopolistic competitive market

Answer 10

• Consumers will have greater choice due to product differentiation.
• E.g in restaurants better food tastes/choice, hairdressers different styles and quality of service.
• Evaluation : However this may not be true for all monopolistic industries e.g taxis, plumber, where consumers just want the lowest price.

Question 11

Disadvantages of monopolistic competition for consumers in a monopolistic competitive market

Answer 11

• P1 : Consumers will face higher prices, firms are allocatively inefficient due to the cost involved in product differentiation. This means consumers will face higher prices and reduced consumer surplus.
• Eval 1: However in theory differentiated products could increase customer utility which negates the effect of higher prices.
• Eval 2 : Due to only a small amount of price making power - price making exploitation and loss of consumer surplus will not be anywhere near as bad a as monopoly
• P2 : There is lack of dynamic efficiency because SNPs do not exist in the long run, meaning consumers lose out over time with lack of innovation due to a lack of profit to reinvest. This means consumers actually loses future new product choices and future price reductions from efficiency innovations
• Eval 1 :
  However, some industries’ innovation is part of how they compete e.g fashion industry. Therefore, consumers may still benefit from new product innovation even if reinvestment is small. since they do make SNPs in the short run.

Question 12

Advantages of monopolistic competition for consumers in a monopolistic competitive market compared to a monopoly.

Answer 12

• Even though firms are not allocatively efficient in a monopoly. Firms cannot exploit consumers with prices that are too high due to other firms selling similar products and high competitive pressures. Therefore the price will be much lower than in a monopoly.

Question 13

Advantages of monopolistic competition for consumers in a monopolistic competitive market compared to a perfectly competitive market.

Answer 13

• In a perfectly competitive market only homogenous goods exits which means consumers don’t have a choice. Consumers are willing to pay a little extra to experience greater choice which gives us utility.