Because you already know about competition from Episode 26, and monopoly from Episode
27, you actually have all the information you need to analyze a monopolistically competitive
market.
As the name of the structure suggests, it's something a mashup of the characteristics
of a perfectly competitive market and those of a monopoly market.
It's competitive, so, like perfect competition, there are large number of sellers -- a large
enough number so that no individual can affect the overall market -- and (as the large number
of competitors would suggest) there's free entry and exit; firms find no substantial
barriers to entering or departing this market.
But, moving the direction of the monopoly, the monopolistic competitor’s product is
differentiated, albeit only slightly, from the products produced by its rivals.
This product differentiation gives the monopolistically competitive firm a small amount of control
over the price it can charge.
Not a lot of control, because the products are still highly similar, but a little control.
Think back to the toothbrush example from Episode 25: toothbrushes are toothbrushes,
with small differences, like angled heads, or rubber-grip handles, or the ability to
play a song to tell you how long to brush your teeth.
If I, as the customer, believe that the rubber grip handle is the key to good dental health,
then the rubber-grip handle toothbrush manufacturer will be able to get me to pay a bit more for
the product than for any other kind of toothbrush.
Not too much more, though, or I'll switch to a close substitute.
Notice that in my toothbrush example, there's a real differentiation, where there are physical
differences in the products.
It is possible in this market structure to have artificial differentiation, where two
products are physically identical, but through marketing (say, attractive packaging, or celebrity
endorsements), consumers are convinced that the products are different.
This couldn’t happen in a perfectly competitive market, because of the assumption of perfect
information being available.
But in a monopolistically competitive market, perfect information does not exist, and consumers
can be fooled into believing that products are different by the use of advertising and
marketing.
In the end, as long as consumers perceive the products to be different, then the products
are different; it doesn't matter whether the difference is real or artificial.
So -- in monopolistic competition, there lots of competitors, with highly substitutable
products that have slight differences, AND there's free entry and exit.
What does the market look like?
Well, the demand facing each producer will be a small fraction of the overall market
demand, and the demand will be highly, but not perfectly, elastic.
So whereas the perfectly competitive firm’s demand was horizontal, showing that they had
no control over price, the monopolistically competitive firm's demand will be downward-sloping,
if fairly flat, showing that the firm has a small amount of control over its price.
From here, you can treat the graph much as you treated the monopoly graph.
With a downward-sloping demand, the firm's marginal revenue will lie below its demand
curve.
To find the profit-maximizing output and price for the firm, we need to add the marginal
cost curve, determine where marginal revenue equals marginal cost to get the optimal output,
q*, and then use the demand line to determine how much the firm owner can get the buyers
to pay for those q*units.
Like a monopolist, a monopolistically competitive firm could make money, lose money, or break
even in the short run; but like perfect competition, the picture will change long run -- the firm
will end up just breaking even over time.
Why?
Because not only does the firm have very little market power, remember also the assumption
of free entry and exit -- if a monopolistically competitive firm is making a profit in the
short run, then other firms will see that profit, and they will enter the industry.
This will draw away some customers from the existing firm, lowering demand, and eventually
the existing firm will just break even.
Remember if profits still exist, new firms continue to enter until there are no more
profits to be had.
What if the firm is losing money in the short run?
In the long run, then, some firms will leave; their customers will have to shift other sellers,
so that the remaining firms will see their demand curves increase until such point as
they can break even.
At that point, exit from the industry stops.
So in the long run, like the perfectly competitive firm, the profits are driven to zero.
There is an important difference though; take a look at the two types of firms.
The perfectly competitive firm in the long run always ends up operating at the most efficient
point, that is, the lowest per unit cost on the long-run average total cost curve.
Whereas the monopolistically competitive firm always operates just shy of peak efficiency,
operating at a slightly higher cost, and producing fewer units.
To wrap up, let's do a quick recap of this market structure as compared to perfect competition
and monopoly.
There are a large number of firms, more like perfect competition; with respect to the product
produced, it's not identical across firms, as with perfect competition, but neither is
it unique.
The products are differentiated, but highly similar and therefore highly substitutable.
Entry and exit are easy, which affects the ability to sustain profits.
All types of firms use the MR=MC rule to maximize profit, and any firm could make money, lose
money, or break even in the short run.
But in the long run, only a firm with barriers to entry to protect its profits can sustain
those profits.
What about price and output?
The result will be somewhere between the two extreme structures -- producing more than
a monopoly but less than perfectly competitive market; charging less than monopoly but more
than perfectly competitive market.
NEXT TIME: Oligopoly
TRANSCRIPT0 (MICRO) EPISODE 29: MONOPOLISTIC COMPETITION