IMPERFECT COMPETITION:

Monopolistic Competition Notes

Monopolistic Competition
● Firms often introduce valuable new products or process innovations that give rise to
above-normal rates of return in the short run. In the long run, however, entry and
imitation by new rivals erode the dominant market share enjoyed by early innovators,
and profits eventually return to normal.

● The partly competitive, partly monopolistic market structure encountered by firms in

the apparel, food, hotel, retailing, and consumer products industries is called
monopolistic competition.

● Monopolistic competition characterizes an industry in which many firms offer products

or services that are similar (but not perfect) substitutes. Barriers to entry and exit in a
monopolistic competitive industry are low, and the decisions of any one firm do not
directly affect those of its competitors.

● Given the lack of perfect substitutes, monopolistically competitive firms exercise some
discretion in setting prices—they are not price takers. However, given vigorous
competition from imitators offering close but not identical substitutes, such firms enjoy
only a normal risk-adjusted rate of return on investment in long-run equilibrium.

● Monopolistic competition is similar to perfect competition in that it entails vigorous

price competition among a large number of firms. The major difference between these
two market structure models is that consumers perceive important differences among
the products offered by monopolistically competitive firms, whereas the output of
perfectly competitive firms is homogeneous. This gives monopolistically competitive
firms at least some discretion in setting prices. However, the availability of many close
substitutes limits this price-setting ability and drives profits down to a normal risk-
adjusted rate of return in the long run.

● Examples include stores that sell different styles of clothing; restaurants or grocery
stores that sell different kinds of food; and even products like golf balls or beer that may
be at least somewhat similar but differ in public perception because of advertising and
brand names. When products are distinctive, each firm has a mini-monopoly on its
particular style or flavor or brand name. However, firms producing such products must
also compete with other styles and flavors and brand names.
Dynamic Nature Of Competition
● The real-world markets are not static in nature. In other words, it changes over time as a
result of emerging advancements and improvements in business processes. There are
markets that were regarded as oligopolistic in nature but have evolved to being
monopolistically competitive in the present.
● For example, as late as the mid 1980s, it seemed appropriate to regard the automobile
and personal computer manufacturing markets as ‘oligopolistic’ (few large firms
dominating the market) in nature. Today, it seems fairer to regard each industry as
monopolistically competitive (large number of competing firms, but products sold are
not identical).
● In the automobile industry, earliest companies like Mercedes-Benz, Peugeot, Ford,
Daimler Chrysler, have found Toyota, Honda, Nissan, Suzuki, and many other emerging
automobile companies to be powerful competitors in the market.
● In many formerly oligopolistic markets, the market discipline provided by a competitive
fringe of smaller domestic and foreign rivals is sufficient to limit the potential abuse of a
few large competitors.

Characteristics Of Monopolistically Competitive Markets

Monopolistic competition exists when individual producers have moderate influence over
product prices, where each product enjoys a degree of uniqueness in the perception of
customers. This market structure has some important similarities and dissimilarities with
perfectly competitive markets.

Monopolistic competition is characterized by:

a. Large numbers of buyers and sellers.

b. Product heterogeneity.
c. Free entry and exit.
d. Perfect dissemination of information.

a) Large numbers of buyers and sellers. Each firm produces a small portion of industry
output, and each customer buys only a small part of the total.
 A monopolistically competitive industry contains a large number of small firms,
each of which is relatively small compared to the overall size of the market. This ensures
that all firms are relatively competitive with very little market control over price or
quantity. In particular, each firm has hundreds or even thousands of potential
competitors.

Consider this example of monopolistic competition from the Shady Valley

restaurant market. Manny Mustard's House of Sandwich is one of 2,000 eateries
scattered throughout Shady Valley. Each restaurant is in competition with every other.
With 2,000 restaurants in total, none has a great deal of market control. If the going
price of lunch is about $5, then each restaurant charges "about" $5 for lunch. Should
one try to charge $10 or $20, then it will literally price itself out of the market as the
quantity demanded drops to zero and customers switch to competitors.

Monopolistic competition is a realistic description of competition in a wide

variety of industries. As in perfectly competitive markets, a large number of competitors
make independent decisions in monopolistically competitive markets. A price change by
any one firm does not cause other firms to change prices. If price reactions did occur,
then an oligopoly market structure would be present.

b) Product heterogeneity. The output of each firm is perceived to be essentially different

from, though comparable with, the output of other firms in the industry.

The most distinctive characteristic of monopolistic competition is that each

competitor offers a unique product that is an imperfect substitute for those offered by
rivals. Each firm is able to differentiate its product from those of its adversaries to
achieve above-market returns.

Product differentiation takes many forms. Quality differentials, packaging, credit

terms, or superior maintenance service can all differentiate products, as can advertising
that leads to brand-name identification.

There are four main types of differentiation:

● Physical product differentiation - This refers to how firms differentiate their

products based on size, design, color, shape, performance, and features.
Consumer electronics, for example, may be easily differentiated physically.

● Marketing differentiation - This is where firms try to differentiate their products

through distinctive packaging and other promotional strategies. Breakfast
cereals, for example, can easily be differentiated through packaging.
● Human capital differentiation - where the firm creates differences through the
skills or expertise of its employees, the level of training acquired, distinctive
uniforms, and so on.

● Differentiation through distribution – this includes distribution via mail order or

through internet shopping, such as Amazon.com, which differentiates itself from
traditional bookstores by selling online.

The effect of product differentiation is to create downward-sloping firm

demand curves in monopolistically competitive markets. Unlike a price taker
facing a perfectly horizontal demand curve, the firm is able to independently
determine an optimal price/output combination. The degree of price flexibility
enjoyed depends on the strength of product differentiation. The more
differentiated a firm’s product, the lower the substitutability of other products
for it. Strong differentiation results in greater consumer loyalty and greater
control over price.

This is illustrated in Figure 11.1, which shows the demand curves of firms
A and B. Consumers view firm A’s product as being only slightly differentiated
from the bulk of industry output. Because many other firms offer acceptable
substitutes, firm A is close to being a price taker. Conversely, firm B has
successfully differentiated its product, and consumers are therefore less willing
to accept substitutes for B’s output. Firm B’s demand is relatively less sensitive to
price changes.
c) Free entry and exit. Firms are not restricted from entering or leaving the industry as
there are no major barriers to entry or exit.

While some firms face high start-up costs or need government permits to enter
an industry, this is not the case for monopolistically competitive firms. Likewise, a
monopolistically competitive firm is not prevented from leaving an industry as is the
case for government-regulated public utilities.

For example, if Manny Mustard wants to leave the restaurant industry and enter
the retail shoe sales industry, he can do that without restriction. Likewise if Bobby (of
Bobby's Bunyon-Free Footware) wants to leave the retail shoe industry and enter the
restaurant industry, he can do so without restraint. Manny Mustard and Bobby are not
faced with heavy up-front investment costs, such as the construction of a multi-million
dollar factory, that would prevent them from entering a monopolistically competitive
industry and competing on nearly equal ground with existing firms.
d) Perfect dissemination of information. Cost, price, and product quality information is
known by all buyers and all sellers.

In monopolistic competition, buyers do not know everything, but they have

relatively complete information about alternative prices. They also have relatively
complete information about product differences, brand names, etc. Moreover, each
seller also has relatively complete information about the prices charged by other sellers
so that they do not inadvertently charge less than the going market price.

Manny Mustard, for example, knows that the going price of club sandwiches in
Shady Valley is about $5.50, give or take a little. All of the sandwich buyers know that
the going Shady Valley price of club sandwiches is about $5.50, give or take a little.
Price/Output Decisions Under Monopolistic Competition
Monopolistic competition embodies elements of both monopoly and perfect competition. The
monopoly aspect is most forcefully observed in the short run.

Definition of items in the graph:

- Demand curve (D) shows the quantity of an item that consumers in a market are willing
and able to buy at each price point.
- Marginal revenue curve (MR), is the additional revenue that a producer receives from
selling one more unit of the good that he produces. Graphically, it is always below the
demand curve when the demand curve is downward sloping because, when a producer
has to lower his price to sell more of an item, marginal revenue is less than price.
- Average cost (AC), also called average total cost, is the total cost divided by quantity
produced.
- Marginal cost (MC) is the incremental cost of the last unit produced
 In the graph, with the demand curve, D1, and its related marginal revenue curve, MR1,
the optimum output, Q1, is found at the point where MR1 = MC. This is the quantity where
profit maximization happens. Short-run monopoly profits equal to the area P1LMAC1 are
earned.
Short-run monopoly profits can be derived from new product introductions, product
and process improvements, creative packaging and marketing, or other factors such as an
unexpected rise in demand.

Over time, short-run monopoly profits attract competition, and other firms enter the
industry. This competitive aspect of monopolistic competition is seen most forcefully in the long
run. As competitors emerge to offer close but imperfect substitutes, the market share and
profits of the initial innovating firm diminish.

In the graph, Firm demand and marginal revenue curves shift to the left as, for example,
from D1 to D2 and from MR1 to MR2 in Figure 11.2. Optimal long-run output occurs at Q2, the
point where MR2 = MC. Because the optimal price P2 equals ATC2, where cost includes a
normal profit just sufficient to maintain capital investment, economic profits are zero.
The price/output combination (P2Q2) describes a monopolistically competitive market
equilibrium characterized by a high degree of product differentiation. If new entrants offered
perfect rather than close substitutes, each firm’s long-run demand curve would become more
nearly horizontal, and the perfectly competitive equilibrium, D3 with P3 and Q3, would be
approached. Like the (P2Q2) high-differentiation equilibrium, the (P3Q3) no-differentiation
equilibrium is something of an extreme case. In most instances, competitor entry reduces but
does not eliminate product differentiation. An intermediate price/output solution, one between
(P2Q2) and (P3Q3), is often achieved in long-run equilibrium. Indeed, it is the retention of at
least some degree of product differentiation that distinguishes the monopolistically competitive
equilibrium from that achieved in perfectly competitive markets.

A firm will never operate at the minimum point on its average cost curve in
monopolistically competitive equilibrium. Each firm’s demand curve is downward sloping and is
tangent to the ATC curve at some point above minimum ATC. However, this does not mean that
a monopolistically competitive industry is inefficient.
The very existence of a downward-sloping demand curve implies that consumers value an
individual firm’s products more highly than they do products of other producers. The higher
prices and costs of monopolistically competitive industries, as opposed to perfectly competitive
industries, reflect the economic cost of product variety. If consumers are willing to bear such
costs, then such costs must not be excessive. The success of branded products in the face of
generic competition, for example, is powerful evidence of consumer preferences for product
variety

Illustration Of Monopolistically Competitive Equilibrium

EXAMPLE:

Assume that the Skyhawk Trailer Company, located in Toronto, Ontario, owns patents
covering important design features of its Tomahawk II, an ultralight camping trailer that can
safely be towed by high-mileage subcompact cars. Skyhawk’s patent protection has made it
very difficult for competitors to offer similar ultralight trailers. The Tomahawk II is highly
successful, and a flood of similar products can be expected within 5 years as Skyhawk’s patent
protection expires.

Skyhawk has asked its financial planning committee to identify short- and long-run
pricing and production strategies for the Tomahawk II. To facilitate the decision-making
process, the committee has received the following revenue and cost data from Skyhawk’s
marketing and production departments:

WHERE:

· TR- Revenue (in dollars)

· Q- Quantity (in units)

· MR- Marginal Revenue (in dollars)

· TC- total cost per month, including a risk-adjusted normal rate of return on investment
(in dollars)

· MC- marginal cost (in dollars)

FIRST STEP: determine the optimal price/output combination if the committee were to decide
that Skyhawk should take full advantage of its current monopoly position and maximize short-
run profits. To find the short-run profit-maximizing price/output combination, set Skyhawk’s
marginal revenue equal to marginal cost and solve for Q:

Therefore, the financial planning committee should recommend a $15,320 price and
300-unit output level to Skyhawk management if the firm’s objective is to maximize short-run
profit. Such a planning decision results in roughly $1.9 million in profit during those months
when Skyhawk’s patent protection effectively deters competitors.

ANOTHER ASSUMPTION:

Now assume that Skyhawk can maintain a high level of brand loyalty and product
differentiation in the long run, despite competitor offerings of similar trailers, but that such
competition eliminates any potential for economic profits. This is consistent with a market in
monopolistically competitive equilibrium, where P = AC at a point above minimum long-run
average costs. Skyhawk’s declining market share is reflected by a leftward shift in its demand
curve to a point of tangency with its average cost curve. Although precise identification of the
long-run price/output combination is very difficult, the planning committee can identify the
bounds within which this price/output combination can be expected to occur.

The high-price/low-output combination is identified by the point of tangency between

the firm’s average cost curve and a new demand curve reflecting a parallel leftward shift in
demand (D2 in Figure 11.2). This parallel leftward shift assumes that the firm can maintain a
high degree of product differentiation in the long run. The low-price/high-output equilibrium
combination assumes no residual product differentiation in the long run and it is identified by
the point of tangency between the average cost curve and a new horizontal firm demand curve
(D3 in Figure 11.2). This is, of course, also the perfectly competitive equilibrium price/output
combination.

The equilibrium high-price/low-output combination that follows a parallel leftward shift

in Skyhawk’s demand curve can be determined by equating the slopes of the firm’s original
demand curve and its long-run average cost curve. Because a parallel leftward shift in firm
demand results in a new demand curve with an identical slope, equating the slopes of the firm’s
initial demand and average cost curves identifies the monopolistically competitive high-
price/low-output equilibrium. For simplicity, assume that the previous total cost curve for
Skyhawk also holds in the long run. To determine the slope of this average cost curve, one must
find out how average costs vary to output.
 This high-price/low-output monopolistically competitive equilibrium results in a
decrease in price from $15,320 to $9,090 and a fall in output from 300 to 125 units per year.
Only a risk-adjusted normal rate of return will be earned, eliminating Skyhawk’s economic
profits. This long-run equilibrium assumes that Skyhawk would enjoy the same low-price
elasticity of demand that is experienced as a monopolist. This assumption may or may not be
appropriate. New entrants often have the effect of both cutting a monopolist’s market share
and increasing the price elasticity of demand. It is often reasonable to expect entry to cause
both a leftward shift and some flattening in Skyhawk’s demand curve. To see the extreme limit
of the demand curve–flattening process, the case of a perfectly horizontal demand curve can be
considered.

The low-price/high-output (perfectly competitive) equilibrium combination occurs at the

point where P = MR = MC = AC. This reflects that the firm’s demand curve is perfectly
horizontal, and average costs are minimized. To find the output level of minimum average
costs, set MC = AC and solve for Q:

Under this low-price equilibrium scenario, Skyhawk’s monopoly price falls in the long
run from an original $15,320 to $8,640, and output falls from the monopoly level of 300 units to
the competitive equilibrium level of 200 units per month. The company would earn only a risk-
adjusted normal rate of return, and economic profits would equal zero.

Following the expiration of its patent protection, management can expect that
competitor entry will reduce Skyhawk’s volume from 300 units per month to a level between Q
= 125 and Q = 200 units per month. The short-run profit-maximizing price of $15,320 will fall to
a monopolistically competitive equilibrium price between P = $9,090, the high-price/low-output
equilibrium, and P = $8,640, the low-price/high-output equilibrium. In deciding on an optimal
short-run price/output strategy, Skyhawk must weigh the benefits of high near-term
profitability against the long-run cost of lost market share resulting from competitor entry. Such
a decision involves consideration of current interest rates, the speed of competitor imitation,
and the future pace of innovation in the industry, among other factors.

Source:
Fundamentals of Managerial Economics (Mark Hirschey)