L17 - Monopolistic Competition Flashcards
What is the competition spectrum?
Goes from:
- Perfect Competition
- Monopolistic Competition
- Oligopoly
- Monopoly
What are the two types of Perfect Competition?
Perfect competition & pure monopoly are the extremes of the competition spectrum
In reality, most firms:
(a) face some competition (as opposed to monopoly)
(b) are not price takers (as opposed to perfect competition)
What are the two types of Imperfect Competition?
In the middle of this spectrum, we have imperfect competition
- Firms have some degree of market power (can raise price above marginal cost)
We are going to learn about forms of imperfect
competition:
(a) monopolistic competition
(b) oligopoly
What is Monopolistic Competition?
- This model is a hybrid between monopoly and competition
- There are many sellers that compete with each other to sell their goods & services
- But each sellers can influence the price they charge for their goods and services
- They have this ‘market power’ because –> their products are differentiated, so they are imperfect substitutes for each other
- A firm can set a high price without losing all of its customers to low-priced rivals
What are the two different ways of Product Differentiation?
1) horizontal differentiation
quality is the same but the best depends on tastes
(2) vertical differentiation
quality differs…
What are the Assumption of Monopolistic Competition?
- We retain A(1) and A(2) from lecture 1 –> buyers are price takers and buyers and sellers have complete information
A(3): SELLERS ARE PRICE MAKERS –> A price maker can influence the price which it sells its output
This has two parts:
(a) A seller sells more when its price is lower
(b) the seller’s output choice does not trigger a reaction its rivals
A(4): ENTRY IS FREE–> A potential seller can enter the market in the long run without incurring costs that
an incumbent seller would not incur
- Entry is a long-run decision: all factors of production must be able to change
- Notice that we made A(3) for monopoly and A(4) for perfect competition
What is the Market Structure of a Monopolist Market?
- SIZE & NUMBER OF SELLERS –> Many, small
- Sellers will not respond to each others output choices if there are lots in the market (This does not lead to price taking behaviour on its own
- BARRIERS TO ENTRY –> Low
- Firms must be able to enter the market
- PRODUCT SUBSTITUTABILITY –> Differentiated
- Buyers may prefer one differentiated product to another
(1) horizontal – same quality, different tastes e.g. Mercedes v Audi
(2) vertical – better quality, same tastes e.g. Mercedes v Ford - A seller can raise the price of its product and not lose all of its sales
- Its demand curve slopes downward, even when there are many firms in the market
What is Short-Run Equilibrium under Monopolistic competition?
- Since a seller is a price maker, its demand curve is downward sloping
But its demand curve of is affected by the number of sellers there are in the market - Why? The more sellers, the fewer buyers there are to go around
-SIMPLIFY –> assume sellers are symmetric
For costs: this means their cost curves are the same shape
- For demand: it is less realistic but it simplifies things considerably
EXAMPLE: Suppose there are 4000 people who regularly frequent 40 pubs
- At the market price, each pub would have 100 people (= 4000 people/40 pubs)
- Now suppose the number of pubs increased by 10 and the price does not change
- Each pub would have 80 regulars (i.e. 4000 people/50 pubs)
Incumbents would lose 20 people to entrants, who each attract 80 people
What does the Short-Run Equilibrium under Monopolistic Competition look like on a graph?
- Both the total market and individual sellers diagrams have Price (P/p) on the y-axis and Quantity Demanded (Q/q) on the x-axis
- on the sellers diagram we have a negative gradient AR Line and MR line to the left of it
- A positive MC curve and a flatter positive AVC curve to the diagonal right of the MC curve
- Equilibrium occurs at the quantity and price on the AR line directly above MR=MC
- On the market graph there is a negative gradient line for demand
- Equilibrium is at price p* and quantity nq(P*,n)
What is the effect of more sellers moving into a monopolistic market?
- When there are more sellers there are less buyers to go around
- so the sellers demand curve shifts to the left
- and the price then falls
What is Long-Run equilibrium like under Monopolistic Competition?
- The long-run equilibrium analysis is similar to that of perfect competition:
- we need to consider the fact that in the long-run
(a) all factors are variable which has an impact on the seller’s costs
(b) other sellers can freely enter the market
As a result, the equilibrium must ensure that:
- incumbent sellers will not leave the market, and
- potential sellers will not enter the market
- This implies that sellers make normal profit in the long-run (zero economic profit)
What is the effect Long-Run Equilibrium under Monopolistic Competition by the cost curves?
- In the long-run, the cost curves are flatter than in the short-run
- Therefore the Sellers graph just looks the same with a flatter LRMC curve and LRAC curve
What is the effect Long-Run Equilibrium under Monopolistic Competition by entry of new firms?
- Firms will enter the market until long-run profits are zero –> Shifts every demand curve to the left
- The zero profit condition is at: p{LR} = AR{LR} ( at a tangent) = LRAC
- this will also be at the point above MR{LR}=LRMC
- The graph for the Sellers diagram now just shifts LRAC up
How does Monopolistic Competition compare with Perfect Competition on a graph?
- With Price (P) on the y-axis and Quantity (Q) on the x-axis
- With a line at P=D{L}=AR=MR under perfect competition
- a positive LRMC curve and a tangential LRAC which meets the Demand curve at the point where MR=LRMC –> making 0 economic profits
- Adding monopolistic competition with the negative line of D=AR which is at a tangent to the LRAC and an steep negative gradient of MR to the left of the demand line
- At the intersection of MR under monopolistic competition and LRMC the point directly above will be the tangent where D=AR is equal to LRAC
- From these two models of competition we see that more is produced under perfect composition than under monopolistic competition but the price is less
- under perfect competition P=LRMC but under monopolistic competition P > LRMC
- Price under monopolistic competition is greater than the minimum efficient scale –> there is excess capacity as the firms could produce more and reduce there LRAC
How is Price-Cost Margins different between Monopolistic competition and Perfect competition?
- Monopolistic competition- -> price is above marginal cost, even in the long run
- Perfect competition –> price equals marginal cost
How is this consistent with the free entry condition?
- The zero profit condition requires that price is equal to average total cost
- Sellers produce on the downward portion of their average total cost curve,
so marginal cost must be below average total costs
- Thus, for price equal to average total costs, price must be above marginal cost
