Monopolistic Competition

Assumptions of Monopolistic Firm

Large Number of Small firms
Differentiated Products giving some control over the price
No (or very low) Barriers to Entry

The Role of Non Price Competition

Product Differentiation

As we have seen in Perfect Competition, when firms are producing homogenous (same) goods, they are forced to take the market price. This is because if the firm tries to raise the price, consumers will switch to other competitors selling the homogenous product. Therefore, firms can choose to opt for using non-price competition. One form of non-price competition, is to engage in product differentiation. When firms differentiated their products, they will be able to have the power to set their own price as the firm's products are no longer a direct substitute for their competitors. The more a firm is able to differentiate it's product, the more it will be able to have power over the price it sets.

This gives the firm a short run monopoly. Firms can differentiate their products in a number of different ways:

Physical Product - firms can alter the actual physical product to help them differentiate their product as compared to their competitiors.
Quality Differences - firms can change the quality of their good to differentiate their product. They could improve the quality and therefore appear more luxury and allow them to charge a higher price. Or they could use cheaper materials but charge a lower price. For example, Mercedes cars tend to offer more extras such as leather seating or built-in GPS as compared to Fiat, who produce lower cost, affordable city cars.
Location - firms may be able to differentiate their product by the location they operate. For example, a hotel by the airport that offers a cheap, basic accommodation as compared to a 5* hotel beachfront resort.
Service - firms can differentiate their service, which in turn will allow the firm to distinguish itself from its competitors. For example, a hair salon or barbershop may offer additional treatments or services, that its competitors do not, along with its haircuts to attract consumers.
Branding & Advertisement - Advertisements or celebrity endorsements can help differentiate a firms product to its competition and therefore allow the firm to benefit in the short run from increased demand for its product.

Understanding the behaviour of Monopolistic firms

Whiteboard 6.mov

The following video will discuss the behaviour of monopolistic firms. As firms have some power to set their own price due to product differentiation, firms will remain price makers in both the short run and long run. However, due to the low barriers to enter, if a monopolistic firm is making abnormal profits in the SR, other firms will copy their good, which causes the Demand (AR) for the firm making abnormal profits to decrease in the LR and return them to normal profits.

Inefficiency v Product Differentiation

One of the advantages to Monopolistic Competition, compared to Perfect Competition, is that the monopolistic firms will produce differentiated products and provide consumers with more variety. This, however, comes at the cost of firms not operating at the allocative efficient point. The video below explains this trade off.

Whiteboard 6 copy.mov

Evaluating Monopolistic Competition

Advantages of Monopolistic Competition

Product Differentiation: In monopolistic competition, firms can differentiate their products through branding, packaging, features, or marketing. This allows firms to create a unique identity for their products, which can lead to increased customer loyalty and brand recognition. Product differentiation also provides consumers with a variety of choices, catering to their preferences and needs.

Market Efficiency: Monopolistic competition encourages firms to be efficient in order to gain a competitive edge. Firms strive to improve their products, innovate, and offer better customer service to attract consumers. This drive for efficiency can lead to product improvements, technological advancements, and increased overall market productivity.

Variety and Innovation: Due to the freedom of product differentiation, firms in monopolistic competition are incentivised to innovate and introduce new products or features. This results in a wide range of products available in the market, fostering consumer choice and driving competition.

Large number of firms encourages competition and innovation. Due to high number of firms in the market, firms are always looking to maximise profits and therefore may be constantly innovating in order to differentiate goods from their competitiors.

Low barriers to entry allow loss making firms to exit the market easily: Low barriers to entry and exit means that those firms making a loss will be encouraged to exit the market and can freely do so, making the market more efficient and somewhat reallocating resources to other firms who remained in the industry.

More difficult to collude due to large number of small firms. The larger number of small firms in the market makes it harder for firms to collude and form a cartel (Unlike for Oligopolies which is dominated by a large number of small firms). As such, the likelyhood of firms colluding and forming a monopoly are much lower.

Disadvantages of Monopolistic Competition

Higher Prices: In monopolistic competition, firms have the ability to differentiate their products, which can lead to higher prices compared to perfect competition. The costs associated with product differentiation, branding, and advertising are often passed on to consumers, resulting in higher prices.

Excess Product Differentiation: While product differentiation can be an advantage, in monopolistic competition, it can lead to excessive differentiation and the creation of unnecessary or minor product distinctions. This can result in wasteful duplication of efforts and resources, reducing overall market efficiency.

Inefficient Allocation of Resources (P>MC): Monopolistic competition may lead to an inefficient allocation of resources. Due to excess product differentiation, firms may invest resources in marketing and product development rather than in productive activities, such as research and development or cost reduction. This allocation of resources may not be optimal from a societal standpoint.

Reduced Consumer Surplus: Compared to perfect competition, monopolistic competition can lead to reduced consumer surplus. Higher prices and less competitive pricing practices can limit the benefits that consumers can derive from the market. Consumers may have to pay more for differentiated products without experiencing significant gains in utility.

Page updated

Google Sites

Report abuse