Monopolistic Competition and Oligopoly
c h a p t e r13
Many goods and services are traded in markets that contain elements of both monopoly and perfect competition. Theories of monopolistic competition and oligopoly, which we will cover here, are designed to deal with markets that fall between the extreme cases of perfect competition and monopoly.
WHAT IS MONOPOLISTIC COMPETITION?
Monopolistic competition is a market structure where many producers of somewhat different products compete with one another. For example, a restaurant is a monopoly in the sense that it has a unique name, menu, quality of service, location, and so on, but it also has many competitors—others selling prepared meals. That is, monopolistic competition has features common to both monopoly and perfect competition, even though that might sound like an oxymoron—like jumbo shrimp or civil war.
As in monopoly, individual sellers in monopolistic competition believe that they have some market power, but unlike in monopoly, there are many close substitutes coming from other monopolistically competitive firms. A firm in a monopolistically competitive market recognizes the existence of competitors —imposing a limit on the prices it can charge and still sell a particular level of output—but the firm does not consider competitors as rivals that watch it closely. Because of the relatively free entry of new firms, the long-run price and output behavior, and zero long-run economic profits, monopolistic competition is similar to perfect competition.
Monopolistic Competition
s e c t i o n
13.1
_ What are the distinguishing features of monopolistic competition?
_ How can a firm differentiate its product?
252 CHAPTER THIRTEEN | Monopolistic Competition and Oligopoly
To show that some differentiation is perceived rather than real, blind taste tests on beer were conducted on 250 participants.
Four glasses of identical beer, each with different labels, were presented to the subjects as four different brands of beer.
In the end, all the subjects believed that the brands of beer were different and that they could tell the difference between them.
Another interesting result came out of the taste tests—most of the participants commented that at least one of the beers was unfit for human consumption.
SOURCE: R. Ackoff and J. Emshoff, Sloan Management Review, Spring 1976, p. 11.
IS A BEER A BEER?
In The NEWS
CONSIDER THIS:
Product differentiation, whether perceived or real, can be effective. Take another example: In blind taste testing, very few people can consistently distinguish between Coca-Cola and Pepsi, yet there are many loyal customers of each brand. Sometimes the key to product differentiation is that consumers believe they are different.
© Don Couch Photography
However, the monopolistically competitive firm produces a product that is different (that is, differentiated
rather than identical or homogeneous) from others, which leads to some degree of monopoly power. In a sense, sellers in a monopolistically competitive market may be regarded as “monopolists” of their own particular brands, but unlike a firm in the monopoly model, there is competition by many firms selling similar (but not identical) brands. For example, a buyer living in a city of moderate size and in the market for books, CDs, toothpaste, furniture, shampoo, video rentals, restaurants, eyeglasses, running shoes, and music lessons has many competing sellers from which to choose.
THE THREE BASIC CHARACTERISTICS OF MONOPOLISTIC COMPETITION
The theory of monopolistic competition is based on three characteristics: (1) product differentiation, (2) many sellers, and (3) free entry.
Product Differentiation
One characteristic, of monopolistic competition is
product differentiation—the accentuation of unique product qualities, real or perceived, to develop a specific product identity.
The significant feature of differentiation is the buyer's belief that various sellers' products are not the same, whether the products are actually different or not. Aspirin and some brands of over-thecounter cold medicines are examples of products that are very similar or identical but with different brand names. Product differentiation leads to preferences among buyers to deal with or purchase the products of particular sellers.
Monopolistic Competition 253 Restaurants can be very different. A restaurant that sells tacos and burritos compete with other Mexican restaurants, but it also competes with restaurants that sell burgers and fries. Monopolistic competition has some elements of competition (many sellers) and some elements of monopoly power (differentiated products).
Some buyers view these two types of ice cream as being very different even though the ingredients are similar— butterfat and sugar. The differences might include individual tastes and preferences between the two brands of ice cream, choices of flavors, the atmosphere and location of the ice cream shop, and so on.
It is true that some buyers prefer buying the top of the line pens ($425 for one Montblanc Meisterstück 149 fountain pen) while others will settle for inexpensive ballpoint pens ($1 for a dozen). While both pens may serve the same basic writing function, one may deliver a prestige and enjoyment factor for which some buyers are willing to pay.
© 1998 Don Couch Photography © Don Couch Photography
Physical differences
Physical differences constitute a primary source of product differentiation. For example, brands of ice cream (such as Dreyers and Breyers), running shoes (such as Nike and Asics), or fast-food Mexican restaurants (such as Taco Bell and Del Taco) differ significantly in taste to many buyers.
Prestige. Prestige considerations also differentiate products to a significant degree. Many people prefer to be seen using the currently popular brand, while others prefer the “off” brand. Prestige considerations are particularly important with gifts— Cuban cigars, Montblanc pens, beluga caviar, Godiva chocolates, Dom Perignon champagne, Rolex watches, and so on.
Location. Location is a major differentiating factor in retailing. Shoppers are not willing to travel long distances to purchase similar items, which is one reason for the large number of convenience stores and service station mini-marts. Because most buyers realize there is no significant difference among brands of gasoline, the location of a gas station might influence their choices of gasoline. Location is also important for restaurants. Some restaurants can differentiate, their products with beautiful views of the city lights, ocean, or mountains.
Service. Service considerations are likewise significant for product differentiation. Speedy and friendly service or lenient “return” policies are important to many people. Likewise, speed and quality of service may significantly influence a person’s choice of restaurants.
The Impact of Many Sellers
When many firms compete for the same customers, any particular firm has little control over or interest in what other firms do. That is, a fast-food restaurant may change prices or improve service without a retaliatory move on the part of other competing fast-food restaurants, because the time and effort necessary to learn about such changes may have marginal costs that are greater than the marginal benefits.
The Significance of Free Entry
Entry in monopolistic competition is relatively unrestricted in the sense that new firms may easily
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A great view and a romantic setting can differentiate one restaurant from another.
Many firms, differentiate their products by offering unique services; for example, some people shop online because they can order their groceries by phone, fax, or computer and then have them delivered to their homes. There are also new “intelligent” refrigerators in the works. Equipped with a microprocessor, touch screen, bar-code scanner, and communications port, the refrigerator—developed by Frigidaire and ICL, a London-based technology company— allows consumers to automate their grocery shopping.
Whenever someone is low on a given product, they simply swipe the carton past the refrigerator’s bar-code scanner, which adds that item to a list. When the consumer is ready, the list can be transmitted to the local grocer. The groceries will either be delivered to the consumer’s door or packaged for pickup. The fridge can be connected to the Internet via a standard phone line or to an Ethernet network.
SOURCE: http://www.cnn.com/TECH/computing/9904/09/fridgechip.idg/index.html © Steve Mason/PhotoDisc © Courtesy of PeaPod, Inc.
start the production of close substitutes for existing products; this is the case for restaurants, styling salons, barber shops, and many forms of retail activity.
Because of relatively free entry, economic profits tend to be eliminated in the long run, as is the case in perfect competition.
Monopolistic Competition 255
Retailers are reaching the point of no return. Why? Take the Best Buy customer who recently demanded a refund on a handheld video recorder that he insisted was defective. When the store’s repair technicians played back the tape inside, they found the camera had done its job: First was the splashy shot as the camera tumbled into a swimming pool. Then underwater footage as it sank to the bottom. That was where the recording stopped. . . .
Best Buy has quit taking back goods from customers who don’t have a sales receipt. No exceptions. If customers want to bring back an already opened laptop computer or a video camera, they must now pay Best Buy a “restocking fee” equal to 15 percent of the purchase price.
Wal-Mart Stores Inc. of Bentonville, Arkansas, has abandoned its open-ended return offer and set a 90-day limit for most items. The new policy is designed to combat customers who take their sweet time returning merchandise, such as the shopper who several years ago received a refund for a battered thermos. The store later learned from the manufacturer that the thermos had been purchased in the 1950s, before Wal-Mart opened.
Catalog clothier L.L. Bean Inc., which for years didn’t question customers about returns, has decided to crack down. That, a spokeswoman for the Freeport, Maine, company says, is because some shoppers were returning goods they had purchased at garage sales. One even tried to return worn clothes dug out of a closet of a relative who died.
SOURCE: “Without a Receipt You May Get Stuck,” The Wall Street Journal,
November 18, 1996, p. 1.
STORES CRACK DOWN ON RETURN POLICIES
If most stores start applying tougher standards for returned goods, is it possible that a store that keeps a liberal return policy might benefit? It might be one way for a store to differentiate its product from those of its competitors.
1. The theory of monopolistic competition is based on three primary characteristics: product differentiation, many sellers, and free entry.
2. There are many sources of product differentiation, including physical differences, prestige, location, and service.
1. How is monopolistic competition a mixture of monopoly and perfect competition?
2. Why is product differentiation necessary for monopolistic competition?
3. What are some common forms of product differentiation?
4. Why are many sellers necessary for monopolistic competition?
5. Why is free entry necessary for monopolistic competition?
s e c t i o n c h e c k
Courtesy of L.L. Bean
DETERMINING SHORT-RUN EQUILIBRIUM
Because monopolistically competitive sellers are price searchers rather than price takers, they do not regard price as a given by market conditions as do perfectly competitive firms.
Because each firm sells a slightly different product for which there are many close substitutes, the firm’s demand curve is downward sloping but quite flat (elastic). In perfect competition, the demand curve is horizontal because each firm, one of a great many sellers, sells the same homogeneous products.
Given the position of an individual firm’s demand curve, we can determine short-run equilibrium output and price using a method similar to that used to determine monopoly output and price.
The cost and revenue curves of a typical seller are shown in Exhibit 1; the intersection of the marginal revenue and marginal cost curves indicates that the short-run profit-maximizing output will be
q*. By observing how much will be demanded at that output level, we find the profit maximizing price, P*. That is, at the equilibrium quantity, q*, we go vertically to the demand curve and read the corresponding price on the vertical axis, P*, just as we did in monopoly.
THREE-STEP METHOD FOR MONOPOLISTIC COMPETITION
Let us return to the same three-step method we used in Chapters 11 and 12. Determining whether a firm is generating economic profits, economic losses, or zero economic profits at the profitmaximizing level of output, q*, can be done in three easy steps.
1. Find where marginal revenue equals marginal cost, and proceed straight down to the horizontal quantity axis to find q*, the profit-maximizing output level.
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Price and Output Determination in Monopolistic Competition
13.2
_ How are short-run economic profits and losses determined?
_ How is long-run equilibrium determined?
a. Determining Profits b. Determining Losses
(Loss Minimizing Output) Quantity
0 q*
Total Losses
MR D Price
P* C MC ATC
(Profit Maximizing Output) Quantity
0 q* MR D A B A B
Price
Total Profits
Short-Run Equilibrium in Monopolistic Competition SECTION 13.2
EXHIBIT 1
In (a), the firm is making short-run economic profits because the firm’s total revenue, P*Aq*0, at output q* is greater than the firm’s total cost, CBq*0. Because the firm’s total revenue is greater than total cost, the firm has a total profit of area P*ABC. In (b), the firm is incurring a shortrun economic loss because at q*, price is below average total cost. At q*, total cost, CAq*0, is greater than total revenue, P*Bq*0, so the firm incurs a total loss of CABP*.
2. At q*, go straight up to the demand curve and then to the left to find the market price, P*.
Once you have identified P* and q*, you can find total revenue at the profit-maximizing output level, because TR 5 P 3 q.
3. The last step is to find total cost. Again, go straight up from q* to the average total cost (ATC) curve and then left to the vertical axis to compute the average total cost per unit.
If we multiply average total cost by the output level, we can find the total cost (TC 5
ATC 3 q).
If total revenue is greater than total cost at q*, the firm is generating total economic profits. If total revenue is less than total cost at q*, the firm is generating total economic losses. Remember, the cost curves include implicit and explicit costs—that is, even at zero economic profits, the firm is covering the total opportunity costs of its resources and earning a normal profit or rate of return.
SHORT-RUN PROFITS AND LOSSES IN MONOPOLISTIC COMPETITION
Exhibit 1(a) shows the equilibrium position of a monopolistically competitive firm. As we just discussed, the firm produces where MC 5 MR, at output
q*. At output q* and price P*, the firm’s total revenue is equal to P*Aq*0, which is P* 3 q*. At output q*, the firm’s total cost is CBq*0, which is
ATC 3 q*. In Exhibit 1(a), we see that total revenue is greater than total cost, so the firm has a total profit of area P*ABC.
In Exhibit 1(b), at q*, price is below average total cost, so the firm is minimizing its economic loss.
At q*, total cost, CAq*0, is greater than total revenue,
P*Bq*0, so the firm incurs a total loss of CABP*. Other than the shape of the demand curve, this is no different from determining the monopolist’s price and output in the short run.
DETERMINING LONG-RUN EQUILIBRIUM
The short-run equilibrium situation depicted in Exhibit 1, whether involving profits or losses, will probably not last long because there is entry and exit in the long run. If market entry and exit are sufficiently free, new firms will enter when there are economic profits, and some firms will exit when there are economic losses.
When firms are making economic profits, new firms will enter the market. As a result of this influx, there are more sellers of similar products.
This means that each new firm will cut into the demand of the existing firms. That is, the demand curve for each of the existing firms will fall. This decline in demand will continue to occur until the average total cost (ATC) curve becomes tangent (barely touching) with the demand curve and economic profits are reduced to zero, as seen in Exhibit 2.
When firms are making economic losses, some firms will exit the industry. As some firms exit, fewer firms are in the market. This increases the demand for the remaining firms’ products, shifting their demand curves to the right. The higher demand results in smaller losses for the existing firms until all losses finally disappear where the ATC
curve is tangent to the demand curve, as seen in Exhibit 2.
In short, long-run equilibrium occurs at a level of output at which each firm’s demand curve is just tangent to its ATC curve. The point of tangency always occurs at the same level of output as that at which marginal cost is equal to marginal revenue, as seen in Exhibit 2. At this equilibrium point, there are zero economic profits and no incentives for firms to either enter or exit the industry.
Price and Output Determination in Monopolistic Competition 257
© 1998 Sidney Harris
We have seen that both monopolistic competition and perfect competition have many buyers and sellers and relatively free entry. However, product differentiation enables a monopolistic competitor to have some influence over price. Consequently, a monopolistically competitive firm has a downwardsloping demand curve, but because of the large number of good substitutes for its product, the curve tends to be much more elastic than the demand curve for a monopolist.
THE SIGNIFICANCE OF EXCESS CAPACITY
Because in monopolistic competition the demand curve is downward sloping, its point of tangency with the ATC curve will not and cannot be at the lowest level of average cost. What does this mean?
It means that even when long-run adjustments are complete, firms are not operating at a level that permits the lowest average cost of production—the efficient scale of the firm. The existing plant, even though optimal for the equilibrium volume of output, is not used to capacity; that is, excess capacity
exists at that level of output. Excess capacity occurs when the firm produces below the level where average total cost is minimized.
Unlike a perfectly competitive firm, a monopolistically competitive firm could increase output and lower its average total cost, as seen in Exhibit 1(a).
However, any attempt to increase output to attain lower average cost would be unprofitable because the price reduction necessary to sell the greater
258 CHAPTER THIRTEEN | Monopolistic Competition and Oligopoly
Quantity
0 q* MR
PLR 5 ATC DLONG RUN
MC ATC
Long-Run Equilibrium For a Monopolistically Competitive Firm
SECTION 13.2
EXHIBIT 2
Long-run equilibrium occurs at q*, where D 5 ATC and
MR 5 MC.
1. A monopolistic competitive firm is making shortrun economic profits when the equilibrium price is greater than average total costs at the equilibrium output; when equilibrium price is below average total cost at the equilibrium output, the firm is minimizing its economic loss.
2. In the long run, equilibrium price equals average total costs. With that, economic profits are zero, so there are no incentives for firms to either enter or exit the industry.
1. How is the short-run profit-maximizing policy of a monopolistically competitive firm like that of a monopoly?
2. ...
Januszek66