Monopolistic competition
Monopolistic competition has many characteristics from perfect competition and the characteristic of product differentiation from a Monopoly. Whilst first are price makers they are no absolute price makers as there are many small firms and no firm has a significant market share.
The demand curve for monopolistic competitors is elastic as there are many firms, whereas the monopolists is much more inelastic due to the lack of close substitutes. The following diagram can be used to show the cost structure of a monopolistic competitor in the short run, where the shaded area represents supernormal profits.
In the long run the demand curve for the individual firm will shift to the left, as more firms will be producing more differentiated products. This assumes that the market demand remains constant and that demand for the product remains the same as the new firms enter the market.
This shifting of the demand curve stops at a point where the demand curve is tangential to the ATC curve. There is then a single price and quantity at which the firm can produce to break even. No supernormal profits are made as AR = ATC. At any other output ATC >AR, so the firm will make losses.
Efficiency in Monopolistic competition
Qo, the optimum output for society is greater than Qm, so the market is not productively efficient. Qo - Qe is the excess or unused capacity of the firm. This is due to idle capital as the firm has had a reduce production as more firms enter the market.
Pm > MC, so the market is not allocatively efficient.
To utilise this capacity market demand must increase or firms must leave the market. This will increase demand for the product from the individual firm and so utilise some of the firm's excess capacity.
In monopolistic competition consumer surplus is reduced by the shaded region in the above diagram. The consumer is over charges and the firm produces an output below the optimum.
Competition in Monopolistic competition
In monopolistic competition there is lots of non-price competition. The firm can compete on its product through differentiation, the place it sells the product through effective and appropriate distribution and promotion to improve product knowledge such as special offers, advertising and after sale service.
Past paper Question: June 2002, Q3
The existence of many small high street travel agents, each working well below capacity, is a sign of inefficiency.
(a) Using diagrams, explain the short ad long run equilibrium positions of a firm in monopolistic competition.
Monopolistic competition is a market structure in which firms are price makers, there are a large number of small firms producing differentiated products and there are no barriers to entry in the long run.
First producing under this structure are making supernormal profits in the short run. The firm has a downward sloping demand curve and are aiming to maximise profits so product at MC = MR, as shown below. The supernormal profits made in the short run are represented by the shaded area.
In the long run supernormal profits attract new entrants into the market so reduce the demand for each firm, assuming aggregate demand in the market remains unchanged. This erodes profits and leaves under utilised capacity or Qo-Qm, as shown below.
(b) Discuss the view that greater efficiency would result if the travel agent industry showed more characteristics of a monopoly.
The market structure in which the travel agent is operating has many characteristics of monopolistic competition. There are differentiated products as different firms offer different types of holiday, there are low barriers to entry as an individual can set up a company and operate it from home. The Internet has also improved information so near perfect information exists in the market as prices and holidays are easily comparable on the Internet. There are a large number of small firms operating in the market and the market has some other characteristics such as brand loyalty typical of monopolistic competition.
The market for travel agents therefore has most of the characteristics of a monopolistically competitive market. This means that there are too many firms in the market, as competition requires all firms to produce with excess capacity.
If the market structure were a monopoly the firm would be an absolute price maker so could exploit the consumer by over charging them and producing an output lower than the social optimum. Through price discrimination policies the monopolist can reduce consumer surplus. As there is no competition the firm can supply an inferior quality product and operate inefficiently due to the barriers to entry in the market that prevent new entrants.
The firm will charge a price higher than the MC so the firm is not allocatively efficient and the lack of competition does not force the firm to produce at the lowest point on it's ATC curve.
However in the long run under monopolistic competition no supernormal profits are made, whereas under a monopoly supernormal profits are sustained in the long run due to the barriers to entry. These supernormal profits can be used for research and development, which in the case of the travel agent could be research into new holiday destinations.
A pure monopolist can also reduce priced by exploiting economies of scale, especially marketing economies of scale by renting entire hotels through the holiday season. This reduces the firm's costs so lowers the marginal and average total cost curves. The monopolist can pass on this reduction in costs to the consumer in the form of lower prices.
A pure monopolist may also operate more efficiently in the long run than a monopolistic competitor as a monopolistic competitor will have excess capacity as there are too many firms in the market whereas a pure monopolist will not have excess capacity.
In conclusion neither market structure will result in greater efficiency, as both market structures are inefficient in the long run. However, a monopolistic competitor faces competition and this forces them to become more efficient than a pure monopolist who faces no pressure to become efficient, pass savings onto consumers or invest supernormal profits in research and development.
The market structure of the travel agent market is more accurately represented by the oligopoly market structure as a few large firms dominate the market with a large number of small travel agents specialising in particular holidays.
Homework
Revise all diagrams for test next week and above question for timed practise next week.
These notes are from lessons on 29/09/2004 and 06/10/2004.
