LS11 - Monopolistic Competition

Question 1

Monopolistic competition characteristics

Answer 1

• product differentiation (similar goods, so firms have some price making powers through design, marketing, quality, demand curves downward sloping but very elastic as small degree so many close substitutes). The fact that many other firms exist selling similar products ensures that prices cannot be increased too high otherwise firms will lose market share as consumers switch to decent alternatives.
• low barriers to entry/exit (new firms seek to differentiate slightly, but still remove supernormal profits in LR)
• many buyers & sellers (each have relatively weak market/price setting power so AR and MR elastic)
• non-price competition (compete through advertising, brand loyalty, quality rather than lowering prices)
• firms profit maximise (MC=MR)
• imperfect knowledge

Eg. Hairdressers, estate agents, takeaways

Question 2

Monopolistic Comp - short run profit maximisation

Answer 2

• AR and MR downwards sloping as firms have some price setting powers but elastic as small degree of profit differentiation (close substitutes)
• profit maximise at MC=MR up to AR gives price P1
• C1 below P1 so firms make supernormal profit

Question 3

Monopolistic Comp - long run profit maximisation

Answer 3

• supernormal profit in SR attracts new entrants as low barriers to entry/exit.

This shifts the demand curve for the individual firm to the left, a process that keeps happening until AR is tangential to AC and normal profit is being made.
Firm has now reached a long run stable equilibrium, profit max at normal profit with price P2 and Quantity Q2. Long run in monopolistic competition is therefore denied by Normal profit

• increase in market supply = decrease in price level to normal profits (C1 = P1

Question 4

Monopolistic comp (+ and -)

Answer 4

• not producing at bottom of AC curve so not productivity efficiency in SR or LR
• price above marginal cost, AR ≠ MC so no allocative efficiency in SR or LR
  + likely to have dynamic efficiency as differentiated products so need edge over competitors to make profits BUT as firms are small, and goods close substitutes, may be hard to retain profits needed to invest or finance, not as much motivation
• firms less efficient and higher prices but
  + more choice for consumers & may benefit from economies of scale

Question 5

Price discrimination

Answer 5

When different groups of consumers are charged different prices for the same good or service

Question 6

Conditions for which a firm may be able to price discriminate

Answer 6

Firm must have market power - allowing firms to set prices to differentiate consumers and thus price discriminate. Unable to happen in competitive markets but can in monopoly and ologipolies

Firm must have information about consumers and their willingness to pay and there must be identifiable differences between consumers

The consumers must have limited ability to resell the product - otherwise price discrimination wouldn’t work as consumers would engage in arbitrage to try turn a profit by reselling to consumers in other segments of the market

Question 7

Price discrimination diagram

Answer 7

Question 8

Winners and losers of price discrimination

Answer 8

Winners:

Consumers with elastic demand like students and people in low income countries, who end up paying lower prices
Potential for dynamic efficiency gains due to increased profit to spend on investment (COUNTER - no guarantee firms will increase investment, may just reinforce monopoly power of the firm)
Potential for cross subsidy of activities that bring social benefits (subsidise 1 and charge higher price with the other)

Losers:

Consumers with inelastic demand like peak rail travellers and adult cinema goers, who end up paying higher prices (can bring in allocative efficiency here because P>MC)
Costs associated with separating the market (preventing resale through verification checks, price lists etc)
Consumer surplus extracted and turned into producer surplus
Risk of backlash from consumers if they believe price discrimination is unfair (a country being charged higher prices for IKEA furniture than a neighbouring country)