Monopolistic competition is a market structure whereby there is the presence of several sellers in the industry and/or there are close substitutes for goods produced, however, companies have some of market power in their possession. In oligopoly situations firms interact strategically. In monopolistic competition market structure, products sold by the firm are similar but not necessarily identical (Baumol & Blinder, 2011). There is some freedom exists out of entry into the industry and there is extensive technology and prices knowledge. Monopolistic competition possesses majority of the features of perfect competition but does not possess IS perfect competition benchmark. In monopolistic competition, all firms are profit maximizers and there is a free entry when the profit seems to be attractive.
Monopolistic competition tends to depict a blend between monopoly and perfect competition. Monopolistic competition, as compared to perfect competition, contains a huge number of firms that are extremely competitive. When compared to monopoly, firms in monopolistic competition possess a demand curve that is negatively-sloped. In the real world, monopolistic competition is hugely noticeable (Solow, 1998). The economy total production comes from firms that are in a monopolistic competition. The best illustrations of monopolistic competition depicted in the retail trade which includes convenience stores, clothing stores and restaurants. The main characteristics that exist in perfect competition, monopolistic competition, oligopoly, and monopoly can be summarized in the diagram below.
Monopolistic competitive are characterized by resource mobility that is relatively good but not perfect, extensive knowledge that is not perfect, products are similar but not identical, and there is the presence of a massive number of small firms. Monopolistic competition is different from perfect competition in such a manner that production does not occur at cost which is the lowest. Excess capacity of production is left to the firms. The monopolistic competition market concept was advanced by Robinson from Great Britain and Chamberlin from of America.
Every firm in a market that is monopolistically competitive sells a product that is similar but not exactly identical. Goods being sold in the market by firms are close substitutes but are not perfect substitutes. It is important to understand that each good stratifies the same basic needs or wants. Goods may be subtly different or the difference may occur from the perception of consumers. For a reason that may not be clear, consumers treat goods as similar, but different.
Huge Number of Small Firms
An industry that is monopolistically competitive has a huge number of small firms. Firms compared to the size of the market are relatively small. This condition makes firms very competitive relatively with reduced control of quantity or price. In this perspective, every firm faces competition from many other firms whose population is in thousands or hundreds.
In market structures that exhibit monopolistic competition characteristics, buyers are not in possession of knowing everything, but they possess a bank of knowledge that is relatively complete concerning alternative prices. Similarly, they possess relatively complete information concerning brand names, product differences and many others. Each of the sellers relatively information that is complete concerning prices being charged by competitors and production techniques which are available.
Goods, which are produced in monopolistic competition market structures, are the subject to product differentiation. The goods may appear to be the same but contain some individual differences between them. Product differentiation can be achieved through support services, physical differences, and perceived differences (Zhelobodko, Kokovin & Thisse, 2010). The differentiation requires firms in monopolistic competition to carry out extensive advertising in to increase their market share.
In this case, differences in goods only exist from the buyer’s perspective. Physically the goods may be similar. Existing differences can be attributed to different brand names, which may occasion, different packaging of the same product. Material and color of the package may drive the choice of the customer.
In some circumstances, the product of one firm may be very different from that other firm in the physical form. One good may be vanilla, while the other good may be chocolate. One of the good uses aluminum, while the other uses plastic.
Some goods, which may be perceived to be physically similar, also perceived to be identical, may be differentiated by support services provided. Products may be similar or identical, but a retail store may provide express checkout while the other ‘service with a smile’ Product differentiation gives an opportunity for firms operating in market structures that are monopolistically competitive to create some monopoly around themselves.
Revenue and Demand in Monopolistic Competition
The features of monopolistic competition market structure make them have a relatively elastic as opposed to perfectly elastic demand curve. The demand curve of monopolistically competitive firm is shown below.
Demand Curve of Monopolistic Competition
Firms present in a market that is monopolistically competitive, sell output of a wide range within a range of prices that are relatively narrow. Demand in monopolistic competition is relatively elastic since every firm is faced with competition from a wide range of substitutes that are very close. On the other hand, as opposed to a situation in perfect competition, demand in monopolistic competition is not perfectly elastic since the output produced by each firm is slightly different in relation to the other firms. Goods in monopolistic competition maybe closely related, but not necessarily perfect substitutes. In the graph, a firm in monopolistic competition market can sell 10 units of its output within prices ranging from $5.50 to $6.50. The quantity which is demanded by customers drops to zero.
A firm in a market characterized by monopolistic competition features is a price maker and maintains some control over the price. Unlike in a perfect competition situation, a firm in monopolistic competition can lower or raise a price by some margin; a bigger margin is not allowed to goods being close substitutes. Just like a monopoly situation, the price received by a firm in a monopolistic competition market is greater that the marginal revenue. The price is also the average revenue of the firm (Miller, Vandome & McBrewster, 2010). In the graph above, the curve of marginal revenue lies below the average revenue or demand curve. Marginal revenue is below the price since demand is relatively elastic and the disparity is relatively small. For instance, a price of $5 corresponds to an output of 5 units. The marginal revenue obtained for the fifth unit is $4.48, which is less that they price by a small margin. Any firm, which wishes to exercise price discrimination, has to possess some level of market power. In the absence of market power, a firm is not able to charge a price which is higher than the market price. Firms in market situations that are monopolistically competitive do not have full power over the market and, hence, they have a very narrow range of prices that they can fix. If they charge prices which are very high, buyers will switch to competitors since the goods present in the market have very close substitutes. The degree of market control exercised by firms in monopolistic competition is very limited.
Production in the Short-run Monopolistically Competitive Firm
The short-run analysis of monopolistically competitive firm reveals market supply insight. One main assumption made is that a monopolistic competition firm, just like other firms, is motivated by the desire of profit maximization. The firm has a choice of producing the quantity of output which will give the level of profit that is highest. There are other things that firms’ target includes the highest level of production technology, market demand, cost condition and price given.
Monopolistic competition decision for short-run decision can be demonstrated using the graph below.
Monopolistic Competition Short-run Production
The top panel shows the two parts of revenue and cost and profit decision. The green line that is curved slightly indicates the total revenue. Since price is dependant on quantity, the curve for total revenue is not represented by a straight line. The total cost is represented by the red line which is curved. The difference between the total cost and total revenue is profit. This is represented in the lower part which is indicated by the line brown (Corchón, 1990). A firm will target profit maximization through the selection of the output quantity which produces the largest gap between the total cost line in the upper part and revenue line or at the peak of the curve for profit which is located in the lower part. In this illustration, the output quantity needed for profit maximization is 6. Any other quantity output will result into profit which is less.
Long-run Production for Monopolistically Competitive Firm
With all inputs being variable, a firm in a monopolistic competition market reaches equilibrium in the long-run. This happens at an output quantity which realizes increasing returns to scale or economies of scale. At this output level, the demand curve that is negatively sloped is tangent to the segment of the curve of the long-run average cost which is negatively sloped. This situation is realized through an adjustment process that is in two parts. The first part involves exit and entry of firms out of and into the industry (McEachern, 2011). This condition makes sure that firms are not in a position of earning any economic profit and the price attained is equal to the average cost. The second part entails each of the firms pursuing profit maximization in the industry. Every firm produces output quantity, which will equate long-run and short-run marginal cost, to marginal revenue.
Since a firm, in a monopolistic competition market possesses some control of the market and has a demand curve that is negatively sloped, the ultimate outcome of the adjustment in the long-run is two equilibrium conditions, which are:
P = ATC = LRAC = AR
MR = LRMC = MC
With marginal cost being equal to marginal revenue, every firm realizes profit maximization and has no reason of adjusting the factory size or output quantity. With the average cost being equal to price, every firm present in the industry is entitled only to a profit that is normal. Economic profit equals to zero and economic losses are absent. This means that no firm has the desire of exiting or entering the industry. The conditions discussed above are attained separately. Nevertheless, since marginal revenue is not equal to price, the two equations are not equal to each other (Corchón, 1990). This is the opposite of perfect completion. This translates to the fact that monopolist competition does not realize equilibrium in the long-run at the efficient scale of production which is minimal.
Real World (In) Efficiency
A firm in a monopolistic competition market produces output which is less and fixes a price, which is higher as compared to the situation an industry in a perfect competition. Specifically, the price fixed by a firm in monopolistic competition situation is always greater that its marginal cost. The inequality existing between marginal cost and the price goes against the major condition that results into efficiency. In this case, resources are not being utilized to attain the highest possible degree of satisfaction. This inefficiency is realized due to the market control that exists in monopolistic competition (Baumol & Blinder, 2011). A firm in a monopolistic competition market has little control over a small portion of the market, hence, it is faced with a demand curve which is negatively-sloped and marginal revenue is less than the price. During maximizing of profit, the price is equal to marginal cost for a firm in monopolistic competition. Whereas monopolistic competition is inefficient technically, it is less inefficient as compared to other market structure like the monopoly.
Although marginal cost is less than price and, therefore, marginal cost, since the demand curve is elastic relatively, the disparity is often insignificant. For instance, a monopoly, which fixes its price at $100 while having a cost of $20, results into an inefficiency problem that is very serious. On the other hand, the inefficiency resulting from a firm in monopolistic competition that fixes the price at $50 while having a marginal cost of $49.50 is less serious. The nearer the marginal revenue is to price, the nearer a firm in monopolistic competition comes to allocation of resources in accordance with the benchmark of efficiency which is realized through a perfect competition (Miller, Vandome & McBrewster, 2010). In the grand scheme of any economic problems, the inefficiency that results from monopolistic competition is not worth mentioning for good reasons.
Oligopoly and Monopolistic Competition
When studied superficially, monopolistic competition and oligopoly appear to be quite different. Oligopoly has few and large firms which are dominant in the market. On the other hand, monopolistic competition has a huge number of small firms, which possess a little of control of the market. Nevertheless, oligopoly and monopolistic competition are the backbone of the continuum of the market structure. There is no obvious or clear-cut dividing line between oligopoly and monopolistic competition (Zhelobodko, Kokovin & Thisse, 2010). An industry containing three firms can be labeled as oligopoly, whereas, an industry containing three thousand firms is likely to be a monopolistic competition. In another situation, an industry containing close to thirty firms can either be referred to as monopolistic competition or oligopoly. For instance, convenience stores found in a small town will be referred to as oligopoly while the same number of firms in a large city will be referred to as monopolistic competition. Therefore, oligopoly and monopolistic competition may refer to the same situation but in different localities that determine the level of operations. Convenience stores in the small town have greater control of the market.
Monopolistically competitive firms do not enjoy full control of the market situation as compared to the monopoly. In monopoly, there many barriers to entry while, in the monopolistic competition, there is relatively free entry and free exist. As compared to perfect completion, there is some level of price discrimination enjoyed by firms in monopolistic competition. The inefficiency that is realized in monopolistic competition production is not as serious and substantial as that realized in a monopoly situation. Despite this, just like other firm in other industries, firms in monopolistic competition have the target of maximizing profit through efficient allocation of resources. Equilibrium is attained when marginal cost is equal to the marginal revenue. Monopolistically competitive firms share some of the characteristics of perfect completion and monopoly blended together in moderation. It is easy for an industry that is monopolistically competitive to be confused with an industry that is perfectly competitive.