Monopolistic competition and economic efficiency (Монополистическая конкуренция и экономическая)
Matyukhin Anton
ICEF, 2nd year, 2nd group.
Tutor: Natalya Frolova.
ESSAY ON MICROECONOMICS:
Monopolistic competition and economic
efficiency.
Международный институт экономики и финансов, 2 курс,
Высшая школа экономики.
Year 2000, March.
One of the
most important and basic economic issues is the theory of Market Structure. The
meaning of economics as a science is the description and explanation of
different ways of economic agencies’ interactions through commodities,
services, mediums of exchange like money, production processes and other in
order to increase their wellbeing in a materialistic part of life. The
satisfaction, although only partial, of either economic agency could not be
achieved while acting without knowing something about the market, on which it
operates. One can not predict or expect either producers’ or consumers’
behaviour without knowing general profit and utility maximising notions and
conditions. The structure of a market provides this information.
The theory
of Market Structure divides the markets into four most distinctive types. The
polar ones are the pure competition and pure monopoly. Between these extreme
case lie two imperfectly competitive market structures: monopolistic
competition (the one, which is closer to perfect or pure competition, and which
would be described in this essay) and oligopoly (closer to monopoly, but has
more than one but not many large operating firms, lower monopolistic power and
other distinctive features).
The markets,
which combine both the price making of a monopoly with a large number of
suppliers and free- entry conditions of pure competition are the most popular
and wide spread ones. Among these are almost all retail stores like record
shops and clothing shops, food facilities like restaurants and fast-food
enterprises, producers of non-alcoholic beverages like Coca-Cola or Pepsi and a
great variety of others. Because such markets combine the features of monopoly
and competition, they are called monopolistically competitive. This
model is also very interesting and important tool for analysing such issues as
product variety and product choice. It helps us understand whether the market
system leads to the production of the “right” assortment of goods and services
as it is too expensive to produce all conceivable commodities and there is
always a problem of choice.
There are
several characteristic assumptions, which identifies the monopolistic
competition:
1.
Sellers are price makers. The reason for this is that unlike in perfect competition where the
product is identical, there is a slightly differentiated or heterogeneous
product. Even if some firm has a monopolistic right on its trade mark and
other firms are not allowed to produce the identical commodity, they have the
opportunity to produce similar, but slightly different product and compete with
it on the market. The greater is the difference of the firm’s product from
other one’s (can be based even on location), the greater is the monopolistic
power of that firm and the less elastic is the demand curve for its output.
This feature enables it to charge a slightly different price relative to its
competitors without loosing all its customers. Product differentiation leads to
the potentiality for a firm to affect the price for the good or service it
produces. Although this ability is very limited and depends on the degree of
differentiation, a monopolistically competitive firm faces the downward
sloping demand curve like a monopoly or oligopoly (this is the main
characteristic of every imperfect competition market).
Product
differentiation makes this model different from pure competition model.
Economic rivalry takes the form of non-price competition:
1.
Product
differentiation may be physical (qualitative).
2.
Services
and conditions accompanying the sale of the product are important aspects of
product differentiation.
3.
Location
is another type of differentiation.
4.
Brand
names, advertising and packaging lead to perceived differences.
5.
Product
differentiation allows producers to have some control over the prices of their
products.
2.
Sellers do not behave strategically. As there is a large (like in perfect competition) number of small
firms, we assume, that each of them does not have a noticeable effect on the
price decision of other producers, while changing the price for its output.
Thus, firms do not take into consideration the expectation of a reaction of
their competitors to their price and output decision. Buyers & sellers are
independently acting.
3.
All participants have perfect information.
4.
No entry barriers on the market. Neither technological nor legal barriers to entry exist. This
feature is similar to the perfect competition market.
Profit Maximisation in
Monopolistic Competition:
·
In SR, firm sets its output quantity where MR =
MC and sets price higher than the perfect competition firm would do and equal
to the demand for this quantity of production.
·
If P > ATC at that output, firm earns
abnormal or positive economic profit. (Only possible in SR).
·
Existing firms expand the scale of plant in
response to SR profits.
·
In the LR, new firms attracted by the SR profits enter the
industry.
Short-run
price and output decision (no new entrants):
As any
profit- maximising firm,
Monopolistic competitor
(when it does not choose to shut down) produces the output where MC=MR and the
result would be economic profit (ABCD, grey area)
As it was
mentioned earlier, the entry on the market is absolutely free and definitely
new firms’ occurrence affects the demand for the particular firm’s output.
First, the share and thus the profit of each firm in the market decrease with
the increasing number of competitors producing the similar, but non-identical
commodities. The demand curve for the firms’ production shifts to the left and
at an each price, a seller would be able to realise less items of its output.
Second, as the quantity of similar goods’ producers increases the elasticity of
a demand curve for a single firm’s product increases. Thus, demand curve
becomes flatter with the growing quantity of close substitutes. This situation
is described on the graph below:
Long-run
price and output decision:
New entrants,
attracted by abnormal profit, lead to the decrease of each particular firm’s
production by decreasing the demand for it and converge its profits to zero in
LR.
Process of new firms entering the market continues until the
average firm has demand tangent to the LR average cost curve (point B- the
point where it can only break even). At this point the average total costs
(ATC) are equal to average revenue (AR/demand curve), therefore in the long-
run monopolistically competitive firms usually face only normal or zero
economic profit as in perfect competition. But there is a
complicating factor involved with this analysis: some firms might achieve a
measure of differentiation that is not easily duplicated by rivals (patents,
location, etc.) and can realise economic profits even in the long run,
but this is a rather unusual situation.
Now, it is the very time to speak about the monopolistic
competition from the point of view of economic efficiency.
The main issue in welfare economics, which describes not how the
economy works, but how well it works, is the term of economic or Pareto-
efficiency. By definition, “the allocation is Pareto- efficient for a given set
of consumer tastes, resources, and technology, if it is impossible to move to
another allocation, which would make some people better off and nobody worse
off”. To realise the meaning of economic efficiency we must also recall the
definitions of allocative and productive efficiencies:
1.
Allocative
efficiency occurs when price = marginal cost (P=MC), where the right amount of
resources are allocated to the product.
2. Productive efficiency
occurs when price = average total cost (P= ATC), where production occurs using
the least-cost combination of resources.
The monopolistically competitive
firm is not allocatively efficient (misallocate
resources as P > MC), but is a productively
efficient market structure (P = ATC) as it maximizes profits and minimizes its costs.
2. Firm produces the minimum cost level
of output as P = ATC (average-total-cost level of output).
There is an
obvious difference between the point where MC=MR and the price of a
monopolistic competitor (on the graph it is marked as a line from A to B)- its
is called a mark up. And the greater is this mark up, the greater is the
monopolistic power of a firm. Because the demand curve is still downward
sloping, the firm will not reach the long run equilibrium at the minimum point
of the ATC curve. Average costs may also be higher than under pure competition,
due to advertising and other costs involved in differentiation. If there were
fewer firms in industry, each firm could produce the more effective scale of
output, which would be better for consumers. This excess capacity is the
"price" society must pay for product differentiation. In other words,
the price differential paid by the consumer (price difference between perfect
competition and monopolistic competition) is the "price" of product
differentiation. But of course monopolistic competition provides us many good
opportunities important for our wellbeing: the lure of economic profits causes
firms to develop new or improve their old products in order to compete for customers
with other producers of similar but not identical goods and services.