Hi everybody, monopolistic competition, a very interesting real world market structure, a competitive market but with some characteristics of monopoly. We're going to look at characteristics first, we'll then see how firms behave using diagrams, we'll then evaluate using efficiency. So characteristics first, well there are many buyers and sellers in this market, a key characteristic of a competitive market.
Each firm is selling slightly differentiated goods, emphasize that word slightly. Because goods are differentiated, yes, firms are price makers. They can set their own prices, but only slightly.
And that is because there are very good substitutes available. There are lots of other firms. So therefore, firms can't raise prices too significantly, exploiting their price making power.
In that sense, there are price elastic demand curves that firms have here. So it means that, yeah, this is a monopoly characteristic, but you can see how limited it is because of the competition in the market. If there is competition, No surprise that there are low barriers to entry and exit. So if firms want to enter, they can do so at relatively low cost relatively easily. And if firms want to exit, they can do so at low cost relatively easily as well.
There is good information of market conditions. That's very important. And because firms can't raise price significantly to make very high supernormal profits, exploiting their price making ability, we see a lot of non-price competition in monopolistic competition.
Competition based on branding, advertising, quality of product, quality of service, non-price factors. And also we assume that firms are profit maximizers, producing where MC is equal to MR. If we take some really good examples of monopolistically competitive markets, we can take clothing markets, great example, taxis, brilliant example, fast food, restaurants. We can take hairdressers and salons, bars and nightclubs.
These are all the classic, really good examples of monopolistic competition. How do firms behave? There is a difference to firm behavior in the short run and the long run. Let's have a look at the short run first. Your short run diagram is very simply just the monopoly diagram.
Why? Because firms are selling something relatively unique. They've got price making ability. They're going to profit maximize. We're going to end up with very similar outcomes to monopoly.
So here we go. We're going to have downward sloping revenue curves. Now I've said that demand is price elastic, so you could draw them a little bit shallower.
in truth it doesn't matter so much on the diagram it's going to be hard to notice so in your writing you can make reference to the fact that demand curves are price elastic but for now it doesn't matter if they look or not look very price elastic so here we go we're going to have ar which is equal to demand mr which is twice as steep brilliant start we're going to have our average cost curve coming in next so average cost looking something like that and then marginal cost to cut average cost at its lowest point to look something like that brilliant Remember, firms here are profit maximizers. They're going to produce where MR is equal to MC. That's going to give us a quantity. Let's call it Q1. We read the price off the AR curve.
So there we go at P1. And remember, how do we work out the level of profit? Once we get our quantity of Q1, we compare average revenue and average cost. Well, a quantity Q1, average revenue is up there.
Average cost is down there. Let's call that point C1 there. So we can see because average revenue is greater than average cost here. The firm is making super normal profit.
The unit super normal profit is that vertical distance multiplied by Q1 and you get this lovely box of super normal profit. So in the short run it is very possible for firms in monopolistic competition to make super normal profit. Absolutely it is exploiting their price making power given the fact that they are selling a unique good and as a result they can be happy and make these nice profits but crucially In the long run, these profits will not last. They will be eroded away.
Let's see how that happens. In the long run, new firms are going to enter the market being attracted by these supernormal profits. Remember these two crucial characteristics. There are low barriers to entry and there is good information in market conditions. That means that firms can enter the market and they can compete with these established firms and erode away any supernormal profit.
What happens on the diagram is that as new firms enter the market... Demand for individual firms in the market will shift to the left, left, left, as consumers are shared across a large number of new firms now. And demand will keep shifting left, left, left, until average revenue is equal to average cost, i.e. until there is normal profit made. That's the theory. That's how it goes.
How do we draw that on a diagram? It's tricky to get it absolutely right. Therefore, I've written down a very useful process of how to draw this diagram to make sure you get it right every time. We're going to start with our AR and MR curves.
That's just as normal. That's just as normal. So AR and MR twice as steep. We're used to that.
That's fine. But now we're going to draw on marginal cost. That's going to go next. So stick on your marginal cost. Next, we're going to show the profit maximization price and quantity.
Well, profit max is MR equals MC. That's going to give us a quantity. Let's call it Q1.
And it's going to give us a price when we read it off the AR curve. Let's call that P1 there. Great. Now we want to put on our average cost and we know that normal profit is going to be the long run position as new firms enter. This demand curve is shifting left, left, left until normal profit is made.
But remember that marginal cost has to cut average cost at its lowest point. So two things we have to do. We've got to make sure average cost touches average revenue there because that's going to be normal profit. And then marginal cost hits the minimum of average cost.
And that means we're going to have an average cost curve that looks something like this. Perfect. Yeah, it might not look like your nicest average cost curve, but it does the job. And that's the best way of drawing this diagram to make sure you're going to get everything absolutely correct and that the economics is all going to be correct on the diagram as well.
So follow this process. It's a very useful way of getting this diagram correct when otherwise it can be very tricky. And we can see now at quantity Q1. Average revenue is equal to average cost. We have got normal profit here in the long run.
So these are our diagrams. Great. Now let's evaluate this market structure.
Do we see allocative efficiency in monopolistic competition? We'll have a look at Q1. Does price equal marginal cost?
Well, there's the price P1, but marginal cost is way down there. Price is greater than marginal cost. So allocative efficiency is not being achieved in the long run in monopolistic competition. We could look at efficiency in the short run, but long run, which is going to be our stable position over time, is far more important to consider efficiency.
And we can see the answer is no. In truth over there the answer is no as well. So what does that mean?
It means that consumers are exploited, at least in theory. Prices are greater than cost, output is restricted, choice is restricted, all these bad things for consumers. What about productive efficiency?
Well we're not at the minimum point on the average cost curve, so again no, voluntarily forgoing economies of scale. are firms in monopolistic competition. Another reason for higher prices in this market as costs are not being minimized. Is there dynamic efficiency in monopolistic competition?
The answer is no because there is no long-run super normal profit being made. So there is not enough profit to be reinvested back into the company here. Right, so theoretically using our long-run diagram we get to these outcomes don't we with monopolistic competition. Very very inefficient market structure it seems like.
And especially when we compare it to two extremes, perfect competition, allocative efficiency, productive efficiency is attained, dynamic no, monopoly, allocative and productive no, dynamic yes. So at least in these other extremes we get some kind of efficiency, whereas in monopolistic competition it seems like we get zero. That's what the theory says. If you're thinking hard though, we can evaluate to make it sound like monopolistic competition is actually the best market structure.
How can we do that? Well, let's have a look at allocative efficiency. In theory, we say, well, not in theory, it's clear that no, there isn't allocative efficiency in monopolistic comp.
Whereas in perfect competition, yes, there is. In monopoly, no, there... isn't either. So apparently this is as bad as monopoly?
No. First evaluation point here is that look that there is some pretty decent competition in this market which means that the price making ability of these firms is lower. The price exploitation if you want to call it that is not going to be anywhere as near as bad as a monopoly.
The loss of consumer surplus is not going to be anywhere near as bad. So therefore we can say compared to a monopoly, nowhere near as bad. What about compared to perfect comp where there is allocative efficiency?
Remember in perfect competition, there are homogenous goods. Is that what consumers desire? Definitely we can argue no, especially in many markets like clothing, like restaurants.
We don't want homogenous goods there. We like differentiation. And maybe we consumers are willing to pay a little bit more. We're willing to erode a little bit of our consumer surplus for that.
In which case, actually, this allocative inefficiency is not a bad thing. It's quite desirable, especially when the exploitation isn't anywhere near as bad as you might think, given the fact that there are good substitutes available. Productive inefficiency compared to monopoly. nowhere near as bad. Again, there are good substitutes.
Firms can't afford to forego economies of scale to the same extent as monopoly and charge the higher prices. That's the way to evaluate against that. In perfect competition, we say there's productive efficiency. Well, two ways to evaluate this. One is in perfect competition, there might not be very many economies of scale at all, whereas in monopolistic competition there are.
So any economies of scale that are being exploited might be to a greater extent than in perfect comp, and therefore prices may actually still be lower. than in perfect competition. But the other way to look at it is again, that productive inefficiency in monopolistic competition might be due to the product differentiation demands of consumers.
We like variety, our desire for variety might make it harder to exploit economies of scale, much harder if you're producing a wide range of different goods as opposed to just one good. If you're producing just one good, you can bulk buy very easily, you can achieve technical economies very easily, you can achieve financial economies more easily, easily, you can achieve managerial economies more easily, but as soon as you've got different production lines, you've got different products, it's much harder to exploit economies of scale. So again, the productive inefficiency might come out of consumer desire for differentiation, in which case we're willing to pay a slightly higher price for it.
What about dynamic efficiency? Well we say monopoly, it's likely to occur. Imperfect comp, not likely to occur.
In monopolistic comp we say no, but does it have to be a no? We could argue two ways maybe there is dynamic efficiency. First way is if short-run super normal profits are enough to reinvest we can get dynamic efficiency. But maybe a better argument is that in a very competitive market we can still get dynamic efficiency even if normal profits are being reinvested. It could be just part of competition in the market for firms to have to reinvest and take clothing as a good example.
If clothing firms don't reinvest and bring in new fashion lines as new seasons come along they're going to fall behind significantly. So even if the extent of the reinvestment is small we still see dynamic efficiency in monopolistically competitive markets especially if reinvestment is part of the competition. But even if not maybe firms will reinvest to try and get ahead of rivals.
even using very small scale profits to do so. So in that sense, better than perfect comp, and also in monopoly where it might not occur, there are many arguments for dynamic efficiency not to occur in monopoly. You could argue we're more likely to get it in monopolistic comp. So what an incredible way to evaluate and to actually say that monopolistic comp might actually be the best market structure looking at reality.
What a way to overcome the theoretical inefficiencies that we get from the diagrams. So thank you so much guys for watching this video. There's a lot in there for you to think about and very interesting market structure.
I'll see you all in the next video.