Monopolistic competition and economic efficiency ( )

                                                             Matyukhin Anton
                                                  ICEF, 2nd year, 2nd group.
                                                     Tutor: Natalya Frolova.

                          ESSAY ON MICROECONOMICS:

              Monopolistic competition and economic efficiency.

                , 2 ,

                              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  firms  product
     from other ones (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.
    Firm's goal is to take the pure competitions demand curve and shift  it
in the direction of the monopolists demand  curve.  It  does  this  through
price discrimination.  Let us now discuss the profit  maximising  conditions
and the appropriate price-output decision in the short and long runs.
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

   As it was mentioned earlier, the entry on the market is  absolutely  free
and definitely new firms occurrence affects the demand for  the  particular
firms 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
firms 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 firms 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.

As we see on this graph: 1. Price a firm charges its customers  exceeds  the
marginal cost in the long- run, suggesting that  society  values  additional
units of output which are not being produced.
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.

"Monopolistic competition and economic efficiency ( ) "