Uploaded by Mohammed Akhtab Ul Huda

Monopolistic competition

Monopolistic Competition
Is a market structure that contains a large number of firms selling differentiated versions of a product. As all
firms sell differentiated versions of the product being sold, this market structure combines elements from a
monopoly and a perfectly competitive market and is therefore classed as a form of imperfect competition.
The main assumptions that are required for a market to be classed as monopolistically competitive are as
1. Large number of buyers (consumers) and sellers (firms) - this ensures that a large number of substitutes
for the good are being produced.
2. Perfect Information - consumers have the ability to assess each product and carry out price comparisons
between rival firms.
3. No barriers to entry or exit - any firm can enter the market to enjoy profits as there are no barriers of entry
present. However, firms can also freely leave the market costlessly if they are making a loss due to no
barriers to exit being present. It is this assumption of freedom of entry and exit which means that firms in
this type of market structure will always make normal profits in the long-run.
4. Firms produce differentiated products - this means that firms can effectively become price makers of their
own version of the product, especially if the degree of product differentiation is significant.
If firms operate in a market where all of these conditions are met, it creates an environment of monopolistic
competition. This type of market structure is often the most useful from a practical point of view as there are
many examples of high-street shops that compete in this way. For instance, the fast food market is an example
of a cluster of firms that compete in this way. This is because all firms offer a similar convenient cheap service
but offer subtle differences in their service, in order to attract different types of customers, such as: providing
different items on the menu, branding and advertising their products in a unique way and designing and
planning the interior of their restaurants differently.
Product differentiation is the key feature of this market, as by doing so allows firms to compete for consumers
in terms of the quality and individuality of their product rather than just on price. The main aspects of product
differentiation available to firms are:
Customer Service
Extra Features
Skill and Efficiency of Staff
The fact that these firms differentiate their products slightly means that brand loyalty is created amongst their
consumers and therefore they face a downward sloping demand curve (AR) rather than the perfectly elastic
demand curve under perfect competition. This means that firms can charge higher prices without losing all of
their customers - unlike in the perfectly competitive case. But as they still face some close competition from
other firms, the demand curve is not equal to the market demand curve, like in the case of a monopoly. The
downward sloping demand curve means that if firms wish to sell a higher quantity of the good then they must
charge a lower price to do so.
As usual, firms in the market profit maximize where MR=MC and due to the fact that they have some market
power as a result of product differentiation, the price that they charge is represented by the price they can set
according to the demand curve for that specific quantity of goods. As this price is predominantly above the
average cost of production, firms can make supernormal profits. However, it is important to note that
supernormal profits are not always achieved in the short-run, as the ability to make profit in the shot-run
depends on the position of the firm's average cost curve. This means firms can also make normal profit or
economic losses in the short-run as well. The three possible short-run outcomes for firms are shown below:
However, these outcomes only theoretically hold in the short-run as a result of the assumption of no barriers to
entry or exit in the market.
In the case of supernormal profits being made in the short-run, this is eliminated in the long-run because firms
outside of the market are incentivized to join and produce because of the attraction of jointly earning
supernormal profits. However, as there are only a limited amount of customers in the market, the greater the
number of firms in the market, the more diluted the customer base for each incumbent firm becomes. This as a
result causes the demand curve and marginal revenue curves to shift inwards, until only normal profits are
earned by all firms in the market in the long-run.
The opposite process occurs if firms are making economic losses in the short-run.
When it comes to evaluating monopolistic competition, it is all about assessing the efficiency implications of
the market structure and by doing that we can use the theoretical benchmark of perfect competition.
First of all, productive efficiency is not achieved under this type of market structure as firms do not produce at
the minimum of the average cost curve. This is the case in both the short-run and long-run as firms produce at
a higher cost when maximizing profits. This leads to efficiency and welfare losses that are achieved under a
perfectly competitive market structure.
In terms of allocative efficiency, firms in this market structure do not produce where the price is equal to the
marginal cost (P=MC). This is because the product differentiation has allowed them to become price makers
and therefore can set a price above the marginal cost, to the point specified by the demand curve. This means
that compared to a perfectly competitive market, an optimal allocation of resources is not met and as a result a
dead weight loss triangle is created in the process. This means that total welfare is higher under perfect
In terms of assessing the market structure for dynamic efficiency and X-efficiency, it all depends on the extent
of product differentiation in the market. This is because the degree of product differentiation determines the
level and type of competition between firms.
If a product becomes highly differentiated from other products, it effectively becomes a new product on the
market. This essentially means that firms have insulated them from any direct competition as there are no close
substitutes available. By doing so, the firm has transitioned into a new niche market of which they are the only
real providers of this type of good. Doing so, means they start to develop the characteristics of a monopoly and
can now engage in setting their own prices without having to take into account the reaction of rival firms, as
consumers demonstrate brand loyalty towards this differentiated good and on that basis are willing to pay more
for that particular brand. The welfare implications are such that when significant product differentiation takes
place, a wide range of products are created for consumers to choose from, which creates more opportunities for
them. However, the fact that it could create a specific niche market means that the market may suffer from
some of the inefficiencies and welfare losses of a monopoly, which incidentally are more significant than when
competing under monopolistic competition. This factor alone could erode away the extra benefits consumers
gain from having a wider range of product lines available to them.
On the other hand, if product differentiation is slight, then firms will still have to compete with lots of close
substitutes in the market, as the differentiation is not significant enough to distance away from rival products.
This encourages firms to have to engage in non-price competition, as price competition could lead to a price
war. This though can create dynamic efficiency and X-efficiency as firms need to compete to provide the best
product and service in order to convince consumers to buy their version of the product. This in itself, can help
drive up the standards of all firms involved by encouraging product innovations (dynamic efficiency).
However, this form of dynamic efficiency only occurs if firms use any supernormal profits made in the shortrun to pay for research and development projects. Doing so may present firms with an opportunity to become
more efficient over time and make supernormal profits in the long run as well.
A market structure that contains only a small number of large dominant firms. This market structure is a form
of imperfect competition and oligopolies can come in a variety of different forms:
Pure Oligopoly - Small number of firms control the entire market
Realistic Oligopoly - Several large firms dominating a market
Duopoly - Two firms dominating a market
Oligopolistic markets are defined in terms of market structure and market conduct. The market structure
element relates to the number of firms in the market, the extent of barriers to entry in the market and the degree
of interdependence in the market. The market conduct element refers to the strategies that oligopolistic firms
decide to take i.e. will firms engage in competitive pricing strategies or collusive strategies.
The main characteristics of an oligopoly market structure are as follows:
Small Number of Large Firms - Oligopolistic markets tend to have large firms controlling most but not all
of the market. The measure of dominance from a select group of firms can be measured via an n-firm
concentration ratio e.g. 4-firm concentration ratio in the UK Supermarkets Industry.
High Barriers to Entry - High barriers prevent new firms from entering and stealing the supernormal
profits made by the incumbents and allows firms to continue to earn supernormal profits in the long-run.
This is a characteristic similar to a monopoly market structure. These barriers to entry are either naturally
formed or artificially created by incumbents. The artificial barriers to entry include: predatory pricing,
non-price competition, branding, advertising and integration.
Firm Interdependence - The market outcomes for firms depend not only on their own decisions but also
upon other firms' decisions. This means that the profit that firms make depends on the strategies of rival
firms. This characteristic can be represented via game theory.
From a practical point of view, an oligopoly market structure can be applied to many industries within an
economy and can help explain some of the decision-making processes by firms. However, unlike in the case
with perfect competition and monopoly, the theory of how oligopolies behave and act is not a definitive one.
This is because the market outcomes of an oligopoly all depend greatly upon individual circumstances. This is
why there are many different competing theories which seek to explain how oligopolists behave in the market
and how the market equilibrium is reached (e.g. the kinked demand curve model).
The market outcomes reached can range from competitive pricing strategies (perfect competition) to noncompetitive pricing strategies (monopoly). In a competitive oligopoly, each firm pursues their own strategy
(pricing strategy) but the optimal strategy they take depends on the expected strategy of rival firms at the same
time. Therefore, when oligopolist firms are competing amongst each other, price wars are often the outcome.
Under this type of strategy, the oligopoly outcome mirrors that of a perfectly competitive one because in the
long-run firms force the market price down until only normal profits are made. At this point if firms' cut price
any further it will cause them to make economic losses, so the market price remains where firms make only
normal profits. This matches the same outcome under perfect competition. From a welfare point of view,
whilst prices are good for consumers, they are not optimal for oligopoly firms, as supernormal profits are
wiped out by destructively low prices.
However, an oligopoly may not lead to this market outcome, as long as each firm can resist the temptation to
start a price war. For instance, firms may use pricing strategies to re-inforce barriers to entry already in place
and protect long-run supernormal profits. This strategy is created by firms engaging in non-competitive pricing
strategies such as collusion. Under this type of strategy the monopoly market outcome is reached in the longrun as firms make supernormal profits. The strategy works via existing firms co-operating together to maintain
a high market price. Therefore, collusion may benefit all firms by enabling them to earn supernormal profits,
providing no firm has the incentive to cheat to increase their own share of supernormal profits.
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