― Kim Stanley Robinson, Blue Mars
Monopolistic Competition and Oligopoly
(Part C)
by
Charles Lamson
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Price and Output Determination in Monopolistic Competition
Monopolistically competitive industries are made up of a large number of firms, each small relative to the size of the total market. Thus, no one firm can affect market price by virtue of its size alone. Firms do differentiate their products, however. By doing so, they gain some control over price. Product Differentiation and Demand Elasticity Perfectly competitive firms face a perfectly elastic demand for their product: All firms in a perfectly competitive industry produce exactly the same product. If firm A tried to raise price, buyers would go elsewhere and firm A would sell nothing. When a firm can distinguish its product from all others in the mind of consumers, as we assume it can under monopolistic competition, it probably can raise price without losing all quantity demanded. Figure 2 shows how product differentiation might make demand somewhat less elastic for a hypothetical firm.  A monopoly is an industry with a single firm that produces a good for which there are no close substitutes. A monopolistically competitive firm is like a monopoly in that it is the only producer of its unique product. Only one firm can produce Cheerios or Wheat Thins or Johnson's Baby Shampoo or Oreo cookies. However, unlike the product in a monopoly market, the product of a monopolistically competitive firm has many close substitutes competing for the consumers favor. Although the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, it is likely to be more elastic than the demand curve faced by a monopoly.  Price/Output Determination in the Short Run Under conditions of monopolistic competition, a profit-maximizing firm behaves much like a monopolist in the short run. First, marginal revenue is not equal to price, because the monopolistically competitive firm has some control over output price. Like a monopolistic firm, a monopolistically competitive firm must lower price to increase output and a sell it. The monopolistic competitor's marginal revenue curve lies below its demand curve, intersecting the quantity axis midway between the origin and the point at which the demand curve intersects it. The firm chooses that output price combination that maximizes profit. To maximize profit, the monopolistically competitive firm will increase production until the marginal revenue from increasing output and selling it no longer exceeds the marginal cost of producing it. This occurs at the point at which marginal revenue equals marginal cost: MR = MC.    Nothing guarantees that a firm in a monopolistically competitive industry will earn positive profits in the short run. Figure 3(b) shows what happens when a firm with similar cost curves faces a weaker market demand. Even though the firm does have some control over price, market demand is insufficient to make the firm profitable.  Price/Output Determination in the Long Run In analyzing monopolistic competition, we assume entry and exit are easy in the long run. Firms can enter an industry when there are profits to be made, and firms suffering losses can go out of business. However, entry into an industry of this sort is somewhat different from entry into perfect competition because products are differentiated in monopolistic competition. A firm that enters a monopolistically competitive industry is producing a close substitute for the good in question but not the same good. Let us begin with a firm earning positive profits in the short run. Those profits provide an incentive for new firms to enter the industry. The new firms compete by offering close substitutes, driving down the demand for the product of the firm that was earning profits. If several restaurants seem to be doing well in a particular location, others may start up and attract business from them. New firms will continue to enter the market until profits are eliminated. As the new firms enter, the demand curve facing each old firm begins to shift to the left, pushing the marginal revenue curve along with it. (Review parts 58 to 65 if you are unsure why.) This shift continues until profits are eliminated, which occurs when the demand curve slips down to the average total cost curve. Graphically, this is the point at which the demand curve and the average total cost curve are tangent (the point at which they touch and have the same slope). Figure 4 shows a monopolistically competitive industry in long-run equilibrium. At Q* and P*, price and average total cost are equal, so there are no profits or losses.  Look carefully at this tangency, which in Figure 4 is at output level Q*. The tangency occurs at the profit-maximizing level of output. At this point, marginal cost is equal to marginal revenue. At any level of output other than Q*, average total cost (ATC) lies above the demand curve. This means that at any other level of output, ATC is greater than the price that the firm can charge. (Recall that the demand curve shows the price that can be charged at every level of output.) Hence, price equals average total cost at Q* and profits equal zero.  The firm's demand curve must end up tangent to its average total cost curve for profits to equal 0. This is the condition for long-run equilibrium in a monopolistically competitive industry. Even if some monopolistically competitive firms start with losses, the long-run equilibrium will be zero profits for all firms remaining in the industry. (Look back at Figure 3(b), which shows a firm suffering losses.) Suppose many restaurants open in a small area, for example, in Columbus, Ohio, near the intersection of I-270 and Fishinger Road, there are a dozen or so "quick dinner" restaurants crowded into a small area. Given so many restaurants, it seems likely that there will be a "shake-out" sometime in the near future---that is, one or more of the restaurants suffering losses will decide to drop out. When this happens, the firms remaining in the industry will get a larger share of the total business, and their demand curve will shift to the right. Firms will continue to drop out and thus the demand curves of the remaining firms will continue to shift until all losses are eliminated. Thus, we end up with the same long-run equilibrium as when we started out with firms earning positive profits. At equilibrium, demand is tangent to average total cost, and there are no profits or losses.  Second, as Figure 4 shows, the final equilibrium in a monopolistically competitive firm is necessarily to the left of the low point on its average total cost curve. That means a typical firm in a monopolistically competitive industry will not realize all the economies of scale available. (In perfect competition, you will recall, the firms are pushed to the bottom of their long-run average cost curves, and the result is an efficient allocation of resources.) Suppose a number of firms enter an industry and build plants on the basis of initially profitable positions. As more and more firms compete for those profits, individual firms find themselves with smaller and smaller market shares, and they end up eventually with excess capacity." The firm in Figure 4 is not fully using its existing capacity because competition drove its demand curve to the left. In monopolistic competition we end up with many firms, each producing a slightly different product at a scale that is less than optimal. Would it not be more efficient to have a smaller number of firms, each producing only a slightly larger scale?  The costs of less than optimal production, however, need to be balanced against the gains that can accrue from aggressive competition among products. If product differentiation leads to the introduction of new products, improvements in old products, and greater variety, then an important gain in economic welfare may counteract (and perhaps outweigh) the loss of efficiency from pricing above marginal cost or not fully realizing all economies of scale. Most industries that comfortably fit the model of monopolistic competition are very competitive. Price competition coexists with product competition, and firms do not earn incredible profits and do not violate any of the antitrust laws that we discussed in parts 63 and 64 of this analysis. Monopolistically competitive firms have not been a subject of great concern among economic policy makers. Their behavior appears to be sufficiently controlled by competitive forces, and no serious attempt has been made to regulate or control them.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 286-289* end |
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