Monopolistically Competitive Market Case Study
Order ID:89JHGSJE83839 Style:APA/MLA/Harvard/Chicago Pages:5-10
Monopolistically Competitive Market Case Study
A monopolistically competitive market is characterized by:
- many buyers and sellers,
- differentiated products, and
- easy entry and exit.
The monopolistically competitive market is similar to perfect competition in that there are many buyers and sellers who can enter or leave the market easily in response to economic profits or losses. A monopolistically competitive firm, though, is similar to a monopoly in that it produces a product that is different from that produced by all other firms in the market. The restaurant market in New York City provides a good example of a monopolistically competitive market. Each restaurant has its own recipes, decor, ambiance, etc. but also must compete with many other similar restaurants.
Because each firm produces a differentiated product, it won’t lose all of its customers if it raises its prices. Thus, a monopolistically competitive firm faces a downward sloping demand curve for its product. As noted in Chapters 8 and 10, whenever a firm faces a downward sloping demand curve, its marginal revenue curve lies below its demand curve. The diagram below illustrates the relationship that exists between a monopolistically competitive firm’s demand and marginal revenue curves.
While the diagram above seems similar to the demand and marginal revenue curves facing a monopolist, there is a critical difference. In a monopolistically competitive market, the number of firms changes as firms enter or leave the industry. When new firms enter the market, the customers are spread over a larger number of firms and the demand for each firm’s product declines. An increase in the number of firms also tends to result in an increase in the elasticity of demand for each firm’s products (since demand is more elastic when more substitutes are available). The diagram below illustrates the shift in a typical firm’s demand curve that occurs when additional firms enter a monopolistically competitive market.
Short-run and long-run equilibrium in monopolistically competitive markets
Let’s examine the determination of short-run equilibrium in a monopolistically competitive output market.
The diagram below illustrates a possible short-run equilibrium for a typical firm in a monopolistically competitive market. As with any profit-maximizing firm, a monopolistically competitive firm maximizes its profits by producing at a level of output at which MR = MC. In the diagram below, this occurs at an output level of Qo. The price is determined by the amount that customers are willing to pay to buy Qo units of output. In the example below, the demand curve indicates that a price of Po will be charged when Qo units of output are sold.
In a monopoly industry, economics profits could persist indefinitely due to the existence of barriers to entry. In a monopolistically competitive industry, however, the existence of economic profits results in the entry of additional firms into the industry. As additional firms enter, the demand for each firm’s product will fall and become more elastic. This reduction in demand, though, results in a reduction in the level of economic profit received by a typical firm. Entry into the market continues until a typical firm receives zero economic profits. This possibility is illustrated in the diagram below.
The diagram above depicts a monopolistically competitive firm in a state of long-run equilibrium. This firm maximizes its profit by producing an output level of Q’. The equilibrium price is P’. Since the price equals average total cost at this level of output, a typical firm receives a level of economic profit equal to zero. This long-run equilibrium situation is often referred to as a “tangency equilibrium” since the demand curve is tangent to the ATC curve at the profit-maximizing level of output.
In the short run, a monopolistically competitive firm may receive economic losses in the short run. This possibility is illustrated in the diagram below. While each firm will continue operations in the short run, firms will leave the industry in the long run. As firms leave, the demand curves facing the remaining firms will shift to the right and become less elastic. (To see this, note that when firms leave the industry, the remaining firms will receive some of the customers that used to purchase the commodity at the firms that have left the industry.) Exit from the industry will continue until economic profits again equal zero (as illustrated in the diagram below).
Monopolistic competition vs. perfect competition
As noted in Chapter 10, perfectly competitive markets result in economic efficiency since P = MC and firms produce at the minimum level of ATC. The diagram below compares price and output levels for perfectly competitive and monopolistically competitive firms. As this diagram suggests, a perfectly competitive firm produces output at a price (P
) that is less than the price that would be charged by a monopolistically competitive firm (P
). A perfectly competitive firm will also produce a larger quantity of output (Q
) than would be produced by a monopolistically competitive firm (Q
Because monopolistically competitive firms produce at a level of cost that exceeds the minimum level of ATC, they are less efficient than perfectly competitive firms. This efficiency loss, however, is a cost that society must bear if it wishes to have differentiated products. One of the costs of having variety in restaurants, clothing, most types of prepared foods, etc., is that average production costs will be higher than they would be if a homogenous product were produced.
It should be noted, though, that the larger the number of firms in the market, the more elastic will be the demand for each firm’s product. As the number of firms grows very large, the demand curve facing a monopolistically competitive firm will approach the perfectly elastic demand curve that is faced by a perfectly competitive firm. In such a situation, the efficiency cost of product differentiation will be relatively small.
In the short run, monopolistically competitive firms may receive economic profits by successfully differentiating their product. Successful product differentiation, however, will soon be copied by other firms. It is expected that such profits will disappear in the long run. Advertising campaigns may raise the profits of a firm in this industry in the short run, but will successful advertising campaigns will lead to similar efforts by other firms in the industry.
As your text notes, monopolistically competitive firms in the same industry often locate near each other in communities as a result of their attempts to appeal to the median customer in a geographic region. This is why we often see car dealerships and fast-food restaurants locating near each other on a particular street.