Firms in monopolistic competition tend to advertise heavily. Monopolistic competition is a form of competition that characterizes a number of industries that are familiar to consumers in their day-to-day lives. Examples include restaurants, hair salons, clothing, and consumer electronics. To illustrate the characteristics of monopolistic competition, we'll use the example of household cleaning products. Say you've just moved into a new house and want to stock up on cleaning supplies.
Go to the appropriate aisle in a grocery store, and you'll see that any given item—dish soap, hand soap, laundry detergent, surface disinfectant, toilet bowl cleaner, etc. For each purchase you need to make, perhaps five or six firms will be competing for your business. Because the products all serve the same purpose, there are relatively few options for sellers to differentiate their offerings from other firms'. There might be "discount" varieties that are of lower quality, but it is difficult to tell whether the higher-priced options are in fact any better. This uncertainty results from imperfect information: the average consumer does not know the precise differences between the various products, or what the fair price for any of them is.
Monopolistic competition tends to lead to heavy marketing, because different firms need to distinguish broadly similar products. One company might opt to lower the price of their cleaning product, sacrificing a higher profit margin in exchange—ideally—for higher sales.
Another might take the opposite route, raising the price and using packaging that suggests quality and sophistication. A third might sell itself as more eco-friendly, using "green" imagery and displaying a stamp of approval from an environmental watchdog which the other brands might qualify for as well, but don't display. In reality, every one of the brands might be equally effective.
Monopolistic competition implies that there are enough firms in the industry that one firm's decision does not set off a chain reaction. In an oligopoly , a price cut by one firm can set off a price war , but this is not the case for monopolistic competition.
As in a monopoly, firms in monopolistic competition are price setters or makers, rather than price takers. However, the firms nominal ability to set their prices is effectively offset by the fact that demand for their products is highly price elastic. In order to actually raise their prices, the firms must be able to differentiate their product from their competitors by increasing its quality, real or perceived.
Figure Given market demand and marginal revenue, we can compare the behavior of a monopoly to that of a perfectly competitive industry. The marginal cost curve may be thought of as the supply curve of a perfectly competitive industry. The perfectly competitive industry produces quantity Q c and sells the output at price P c. The monopolist restricts output to Q m and raises the price to P m. Reorganizing a perfectly competitive industry as a monopoly results in a deadweight loss to society given by the shaded area GRC. It also transfers a portion of the consumer surplus earned in the competitive case to the monopoly firm.
Now, suppose that all the firms in the industry merge and a government restriction prohibits entry by any new firms.
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Our perfectly competitive industry is now a monopoly. Assume the monopoly continues to have the same marginal cost and demand curves that the competitive industry did. The monopoly firm faces the same market demand curve, from which it derives its marginal revenue curve. It maximizes profit at output Q m and charges price P m. Output is lower and price higher than in the competitive solution. Society would gain by moving from the monopoly solution at Q m to the competitive solution at Q c.
The benefit to consumers would be given by the area under the demand curve between Q m and Q c ; it is the area Q m RC Q c.
An increase in output, of course, has a cost. Because the marginal cost curve measures the cost of each additional unit, we can think of the area under the marginal cost curve over some range of output as measuring the total cost of that output. Thus, the total cost of increasing output from Q m to Q c is the area under the marginal cost curve over that range—the area Q m GC Q c.
Subtracting this cost from the benefit gives us the net gain of moving from the monopoly to the competitive solution; it is the shaded area GRC. That is the potential gain from moving to the efficient solution. The area GRC is a deadweight loss. The monopoly solution raises issues not just of efficiency but also of equity. Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay. It is measured by the area under the demand curve and above the price of the good over the range of output produced.
If the industry were competitive, consumer surplus would be the area below the demand curve and above P c C. With monopoly, consumer surplus would be the area below the demand curve and above P m R. Part of the reduction in consumer surplus is the area under the demand curve between Q c and Q m ; it is contained in the deadweight loss area GRC. But consumers also lose the area of the rectangle bounded by the competitive and monopoly prices and by the monopoly output; this lost consumer surplus is transferred to the monopolist. The fact that society suffers a deadweight loss due to monopoly is an efficiency problem.
But the transfer of a portion of consumer surplus to the monopolist is an equity issue. Is such a transfer legitimate? After all, the monopoly firm enjoys a privileged position, protected by barriers to entry from competition. Should it be allowed to extract these gains from consumers? We will see that public policy suggests that the answer is no.
Advantages of a Monopoly
Regulatory efforts imposed in monopoly cases often seek to reduce the degree to which monopoly firms extract consumer surplus from consumers by reducing the prices these firms charge. The objections to monopoly run much deeper than worries over economic efficiency and high prices. Because it enjoys barriers that block potential rivals, a monopoly firm wields considerable market power. For many people, that concentration of power is objectionable. A decentralized, competitive market constantly tests the ability of firms to satisfy consumers, pushes them to find new products and new and better production methods, and whittles away economic profits.
Firms that operate in the shelter of monopoly may be largely immune to such pressures. Consumers are likely to be left with fewer choices, higher costs, and lower quality. Perhaps more important in the view of many economists is the fact that the existence of economic profits provides both an incentive and the means for monopolists to aggressively protect their position and extend it if possible. These economists point out that monopolists may be willing to spend their economic profits in attempts to influence political leaders and public authorities including regulatory authorities who can help them maintain or enhance their monopoly position.
Graft and corruption may be the result, claim these critics.
Monopolistic competition | Economics Online
Indeed, Microsoft has been accused by its rivals of bullying computer manufacturers into installing its web browser, Internet Explorer, exclusively on their computers. Attitudes about Microsoft reflect these concerns. Even among people who feel that its products are good and fairly priced, there is uneasiness about our seeming dependence on them.
And once it has secured its dominant position, will it charge more for its products? Will it continue to innovate?
Pulling together what we have learned in this chapter on monopoly and previously on perfect competition, Table Most importantly we note that whereas the perfectly competitive firm is a price taker, the monopoly firm is a price setter. Because of this difference, we can object to monopoly on grounds of economic efficiency; monopolies produce too little and charge too much. Also, the high price and persistent profits strike many as inequitable. Others may simply see monopoly as an unacceptable concentration of power.
In this section, we will focus on the differences that stem from market structure and assess their implications. A monopoly firm determines its output by setting marginal cost equal to marginal revenue. It then charges the price at which it can sell that output, a price determined by the demand curve. That price exceeds marginal revenue; it therefore exceeds marginal cost as well.
That contrasts with the case in perfect competition, in which price and marginal cost are equal. The higher price charged by a monopoly firm may allow it a profit—in large part at the expense of consumers, whose reduced options may give them little say in the matter. The monopoly solution thus raises problems of efficiency, equity, and the concentration of power. The fact that price in monopoly exceeds marginal cost suggests that the monopoly solution violates the basic condition for economic efficiency, that the price system must confront decision makers with all of the costs and all of the benefits of their choices.
Efficiency requires that consumers confront prices that equal marginal costs. To contrast the efficiency of the perfectly competitive outcome with the inefficiency of the monopoly outcome, imagine a perfectly competitive industry whose solution is depicted in Figure The short-run industry supply curve is the summation of individual marginal cost curves; it may be regarded as the marginal cost curve for the industry. A perfectly competitive industry achieves equilibrium at point C, at price P c and quantity Q c. Figure Given market demand and marginal revenue, we can compare the behavior of a monopoly to that of a perfectly competitive industry.
The marginal cost curve may be thought of as the supply curve of a perfectly competitive industry. The perfectly competitive industry produces quantity Q c and sells the output at price P c. The monopolist restricts output to Q m and raises the price to P m.
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Reorganizing a perfectly competitive industry as a monopoly results in a deadweight loss to society given by the shaded area GRC. It also transfers a portion of the consumer surplus earned in the competitive case to the monopoly firm. Now, suppose that all the firms in the industry merge and a government restriction prohibits entry by any new firms. Our perfectly competitive industry is now a monopoly.
Assume the monopoly continues to have the same marginal cost and demand curves that the competitive industry did. The monopoly firm faces the same market demand curve, from which it derives its marginal revenue curve. It maximizes profit at output Q m and charges price P m. Output is lower and price higher than in the competitive solution. Society would gain by moving from the monopoly solution at Q m to the competitive solution at Q c. The benefit to consumers would be given by the area under the demand curve between Q m and Q c ; it is the area Q m RC Q c.