Monopolistic competition

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Monopolistic competition is a common market form. Many markets can be considered as monopolistically competitive, often including the markets for restaurants, books, clothing, films and service industries in large cities.

Monopolistic Competition

Monopolistically competitive markets have the following characteristics:

There are many producers and many consumers in a given market.
Consumers have clearly defined preferences and sellers attempt to differentiate their products from those of their competitors; the goods and services are heterogeneous.
There are few barriers to entry and exit^[1].
Have a degree of control over price.

The characteristics of a monopolistically competitive market are almost the same as in perfect competition, with the exception of heterogeneous products, and that monopolistic competition involves a great deal of non-price competition (based on subtle product differentiation). This gives the company a certain amount of influence over the market; it can raise its prices without losing all the customers, owing to brand loyalty. This means that an individual firm's demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

Definition of Monopolistic Competition

Short-run equilibrium of the firm under monopolistic competition

A monopolistically competitive firm acts like a monopolist in that the firm is able to influence the market price of its product by altering the rate of production of the product. Unlike in perfect competition, monopolistically competitive firms produce products that are not perfect substitutes. As such, brand X's product, which is different (or at least perceived to be different) from all other brands' products, is available from only a single producer. In the short-run, the monopolistically competitive firm can exploit the heterogeneity of its brand so as to reap positive economic profit (i.e. the rate of return is greater than the rate required to compensate debt and equity holders for the risk of investing in the firm).

Long-run equilibrium of the firm under monopolistic competition

In the long-run, however, whatever distinguishing characteristic that enables one firm to reap monopoly profits will be duplicated by competing firms. This competition will drive the price of the product down and, in the long-run, the monopolistically competitive firm will make zero economic profit (i.e. a rate of return equal to the rate required to compensate debt and equity holders for the risk of investing in the firm).

Unlike in perfect competition, the monopolistically competitive firm does not produce at the lowest attainable average total cost. Instead, the firm produces at an inefficient output level, reaping more in additional revenue than it incurs in additional cost versus the efficient output level.

[edit] Problems

While monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits; the government would have to regulate all firms that sold heterogeneous products - an impossible proposition in a market economy.

Another concern of critics of monopolistic competition is that it fosters advertising and the creation of brand names. Critics argue that advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. This is refuted by defenders of advertising who argue that (1) brand names can represent a guarantee of quality, and (2) advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands.

There are unique information and information processing costs associated with selecting a brand in a monopolistically competitive environment. In a monopoly industry, the consumer is faced with a single brand and so information gathering is relatively inexpensive. In a perfectly competitive industry, the consumer is faced with many brands. However, because the brands are virtually identical, again information gathering is relatively inexpensive. Faced with a monopolistically competitive industry, to select the best out of many brands the consumer must collect and process information on a large number of different brands. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand (versus a randomly selected brand). Evidence suggests that consumers use information obtained from advertising not only to assess the single brand advertised, but also to infer the possible existence of brands that the consumer has, heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised brand.^[2]

[edit] Notes

^ Joshua Gans, Stephen King, Robin Stonecash, N. Gregory Mankiw (2003). Principles of Economics. Thomson Learning. ISBN 0-17-011441-4.
^ Antony Davies & Thomas Cline (2005). "A Consumer Behavior Approach to Modeling Monopolistic Competition". Journal of Economic Psychology 26: pp. 797-826.