Monopolistic competition
For years, economic theory told us little about market forms in between the two extreme cases: pure monopoly and perfect competition. This gap was partially filled, and the realism of economic theory increased, by the work of Edward Chamberlin of Harvard University and Joan Robinson of Cambridge University during the 1930s. As pointed out above, industries in the real world rarely satisfy the stringent conditions necessary to qualify as perfectly competitive market structures. The world in which we live is invariably characterized by competition of lesser degrees than stipulated by perfect competition. Many industries that we often deal with have market structures that are monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition.
The market structure they analyzed is called monopolistic competition.
A market is said to operate under conditions of monopolistic competition if it satisfies four conditions, three of which are the same as under perfect competition:
(1) Numerous participants — that is, many buyers and sellers, all of whom are small;
(2) freedom of exit and entry; (3) perfect information; and (4) heterogeneity of products — as far as the buyer is concerned, each seller's product is at least somewhat different from every other's.
Notice that monopolistic competition differs from perfect competition in only one respect (item 4 in the definition). While under perfect competition all products must be identical, under monopolistic competition products differ from seller to seller — in quality, in packaging, or in supplementary services offered (such as car window washing by a gas station). The factors that serve to differentiate products need not be "real" in any objective or directly measurable sense. For example, differences in packaging or in associated services can and do distinguish products that are otherwise identical. On the other hand, two products may perform quite differently ' in quality tests, but if consumers know nothing about this difference, it is irrelevant,
In contrast to a perfect competitor, a monopolistic competitor's price will change when its quantity supplied varies. Each seller's product differs from everyone else's. So, in effect, each deals in a market that is slightly separated from the others and caters to a set of customers who vary in their "loyalty" to the particular product. If the firm raises its price somewhat, it will drive some of its customers into the arms of competitors. But those whose tastes make them like this firm's product very much will not switch. If one monopolistic competitor lowers its price. it may expect to attract some trade from rivals. But, since different products are imperfect substitutes, no one competitor will attract away all the business.
Thus, if Harriet's Hot Dog House reduces its price slightly, it will attract those customers of Sam's Sausage Shop who were nearly indifferent between the two. A bigger price cut by Harriet will bring in some customers who have a slightly greater preference for Sam's product. But even a big cut in Harriet's price will not bring her the hard-core sausage lovers who hate hot dogs. So the monopolistic competitor's demand curve is negatively sloped, like that of a monopolist, rather than horizontal, like that of a perfect competitor.
Since each product is distinguished from all others, a monopolistically..competitive firm appears to have something akin to a small monopoly. Can we therefore expect it to earn more than zero economic profit? As with a perfect competitor, perhaps this is possible in the short run. But in the long run, high economic profits j will attract new entrants into a monopolistically competitive market—not entrants with products identical to an existing firm's, but with products sufficiently similar to hurt.
If one ice-cream parlor's location enables it to do a thriving business, it can confidently expect another, selling a different brand, t6 open nearby. When one seller adopts a new, attractive package, rivals will soon follow suit, with slightly different designs and colors of their own. In this way, freedom of entry ensures that the monopolistically competitive firm earns no higher return on its capital in the long run than it could earn elsewhere. Just as under perfect competition, price will be driven to the level of average cost, including the opportunity cost of capital. In this sense, though its product is somewhat different from that of everyone else, the firm under monopolistic competition has no more monopoly роwег than one..operating under perfect competition.
Let us now examine the process that assures that economic profits will be driven to zero in the long run, even under monopolistic competition, and see to what prices and outputs it leads.
MAJOR CHARACTERISTICS OF MONOPOLISTIC COMPETITION.
As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually, if an industry has 50 or more firms (producing products that are close substitutes of each other), it is said to have a large number of firms. However, the number of firms must be large enough that each firm in
the industry can expect its actions go unnoticed by rival firms. Unlike perfect competition, the sellers under monopolistic competition differentiate competitive product. In other words, the products of these firms are not considered identical. It is, in fact, immaterial whether these products are actually different or simply perceived to be so. So long as consumers treat them as different products, they satisfy one of the characteristics of monopolistic competition. This product differentiation is considered a key attribute of monopolistic competition. In many U.S. markets, producers practice product differentiation by altering the physical composition, using special packaging, or simply claiming to have superior products based on brand images and/or advertising. Toothpastes and toilet papers are examples of differentiated products.
In addition to the existence of a large number of firms and product differentiation, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market organization. Also, there should be no collusion among firms in the industry, like price fixing or agreements regarding the market shares of individual companies. With the large number of firms that monopolistic competition requires, collusion is generally difficult, though not impossible. The above mentioned characteristics of monopolistic competition basically yield a market form that is very
competitive, but probably not to the extent of perfect competition.
THE ECONOMICS OF MONOPOLISTIC COMPETITION.
As in the case of perfect competition, a firm under monopolistic competition decides about the quantity of the product produced on the basis of the profit maximization principle—it produces the quantity that maximizes the firm's profit. Also, conditions of profit maximization remain the same—the firm stops production where marginal revenue equals marginal cost of production. But unlike perfect competition, a firm under monopolistic competition has some control over the price it charges, as the firm differentiates its products from those of others. However, this price making power of a monopolistically competitive firm is rather small, since there are a large number of other firms in the industry with somewhat similar products. Remember that a perfectly competitive firm has no price making power—each firm is a price taker, as it produces a product identical to those produced by a large number of other firms in the industry.
An important consequence of the price making power of a monopolistically competitive firm is that when such a firm reduces price, it can attract customers buying other "brands" of the product. The opposite is also true when the firm increases the price it charges for its product. Because of this, price charged for a product is different from the marginal revenue for the product (marginal revenue refers to the increase in total revenue as a result of selling one more unit of the product under consideration). To understand this, consider, for example, that a firm reduces the price for its product. The firm must now sell all units at this lower price. Because the lower price applies to all units sold, not just the last or the marginal unit, price for the product is higher than the marginal revenue at each level of sale. It should be noted that as there are a large number of firms under monopolistic competition, individual firms in the industry are not appreciably affected by a particular firm's behavior.
As mentioned above, a monopolistically competitive firm stops production where marginal revenue equals marginal cost of production—the output level that maximizes its profits (often called the equilibrium output for the firm).
THE DESIRABILITY OF MONOPOLISTIC COMPETITION.
Aforementioned profit maximizing behavior of a monopolistically competitive firm implies that now the price associated with the product (at the equilibrium or the profit maximizing output) is higher than marginal cost (which equals marginal revenue). Thus, the production under monopolistic competition does not take place to the point where price equals marginal cost of production. Remember that, with increased production, price charged (which is higher than marginal revenue at every level of output) is successively falling while the marginal cost of production is rising. Therefore, if a monopolistically competitive firm were to stop production where price is equal to marginal cost (a condition met under a perfectly competitive market structure), output
produced would be greater than when it stops production where marginal revenue equals marginal cost (its profit maximizing output). The net result of the profit maximizing decisions of monopolistically competitive firms is that price charged under monopolistic competition is higher than under perfect competition. In addition,
quantity of the commodity produced under monopolistic competition is simultaneously lower. Thus, both on the basis of price charged and output produced, monopolistic competition is less socially desirable than perfect competition.