Monopolistic Competition Flashcards
What are the 7 characteristics of Monopolistic Competition?
1) The industry is made up of a fairly large number of firms (similar to perfect competition)
2) firms are small relative to the industry, thus, they are primary price takers but do possess a small amount of market power
3) Firms all produce slightly differentiated products (demand curve for firms is relatively elastic due to presence of substitutes) – not as much as in perfect Competition
4) There are low barriers to entry & exit (can do so at relatively low costs, relatively easily)
5) There is good information of market conditions (there isnt perfect information)
6) Firms also compete through non price competition (due to their limited capacity to influence price) (e.g branding)
7) It is also assumed firms are profit maximisers (produce were MC=MR)
Examples of firms in Monopolistic Competition
1) Private schools (e.g AISL, Roads spark)
2) Clothing markets (e.g Woolworths)
3) Taxi’s
4) Fast food (Hungry Lion, KFC)
5) Restaurants (Turn n’ Tender Steakhouse)
Describe through a diagram how firms (making abnormal profits) act in the short run and what will eventually happen in the long run
(Simply the monopoly diagram)
Though a firm in monopolistic competition has a downward-sloping demand and average revenue curve because it possesses a degree of market power, the curve is PED elastic as firms in monopolistic competition only have small amount of market power. In short-run, a firm in monopolistic competition can make abnormal profit or have its average revenue greater than its average cost illustrated by the vertical difference between AR and AC on the diagram. Given that this firm is profit maximizer producing were MR = MC at Q1, the total level profit made by this firm is the vertical difference between AR & AC multiplied by Q1. However, in the long run, these profits will not last as new firms will be incentivized to enter the industry (not the market cause each firm produces a slightly different good) being attracted the abnormal profit being made in the industry. Due to the low barriers to entry and good knowledge firms have of market conditions which means firms can enter the industry. As this happens, marginal revenue will decrease from Mr1 and MR2 and demand for individual firms will decrease from D1 to D2 as consumers are shared across a large number of new firms. The fall in demand will continue to happen until Average revenue is equal to average cost at the profit maximization point, where MR2 = MC, Q2.
How to draw a Monopolistic diagram (steps)
1) Draw Demand curve and MR curve
2) Draw AC curve
- – height at initial point should equal height at end point
3) Draw MC curve
- - intersecting AC curve at its lowest point
4) label quantity (output) at the point where MC = MR
5) Extend output line where MC = MR up until its intersections with the demand curve to find the price
6) Vertical distance between AR (demand. curve) and AC determines the type of profit being made
If adding the occurrence of a firm making normal profit
7) Draw another MR curve Demand curve (crossing where AC would equal Demand curve)
8) Extend output line where MC = MR2 up until its intersections with the demand curve to find the price
State 3 disadvantages of Monopolistic Competition
1) Allocative efficiency cannot be achieved in the long run because though all firms in the industry make normal profit in the long run, for each individual firm, price will always be greater than marginal cost. This means monopolistic competition exploits consumers, creates welfare loss and leads to inefficient market outcomes and inefficient use of resources which is undesirable from the viewpoint of society.
(Can be achieved in perfect competition)
2) Cannot achieve productive efficiency
firms in the long run never operate at the minimum AC, always somewhere to the left — there are voluntarily foregoing economies of scale by not producing at the minimum point of AC — thus, not productively efficient
(Can be achieved in perfect competition)
3) No dynamic efficiency
– as there is no long-run abnormal profit being made, thus, there isn’t enough profit to be reinvested into the firm
(Can be achieved by a Monopoly)
State 3 advantages of Monopolistic Competition
1) Tradeoff between efficiency and product variety is desirable
Beacause variety of goods is present in this market structure, one could argue this makes it better than perfect competition as the differentiation of products is desirable from the viewpoint of consumers in spite of it resulting in allocative inefficiency as consumers like variety. Furthermore, the degree of allocative inefficiency in this market structure would anywhere near as bad as in a Monopoly (the loss of consumer surplus won’t be anywhere near as bad) because of presence of significant amount of competition among firms, limiting price exploitation in this market relative to a Monopoly
2) Arguably are the best equilibrium with regards to productive efficiency
Compared to a Monopoly, productive efficiency is nowhere near as bad, there are substitute goods, and consumer desire for product variety makes it hard for monopolsitic firms to exploit economies of scale. Thus, firms in monopolistic competition cannot afford to forgo economies of scale to the same extent as a monopoly and charge high prices.
With regards to perfect competition, though productive efficiency in possible, there may not be economies of scale at all whereas in monopolistic competition there could be. Thus, economies of scale being exploited might be to a greater extent in monopolistic competition than in perfect competition.
3) In very very competitive monopolistic markets, dynamic efficiency
dynamic efficiency is possible even if normal profits are being reinvested. This could be just part of competition in the market for firms to have reinvest.
(e.g Clothing firms such as Woolworths have to reinvest and sell new fashion lines as new seasons come along, otherwise the will fall behind other firms significantly). Even if the extent of the investment is small, dynamic efficiency is still possible in monopolistic comeptition
