- Explain the main characteristics of a monopolistically competitive industry, describing both its similarities and differences from the models of perfect competition and monopoly.
- Explain and illustrate both short-run equilibrium and long-run equilibrium for a monopolistically competitive firm.
- Explain what it means to say that a firm operating under monopolistic competition has excess capacity in the long run and discuss the implications of this conclusion.
The first model of an imperfectly competitive industry that we shall investigate has conditions quite similar to those of perfect competition. The model of monopolistic competition assumes a large number of firms. It also assumes easy entry and exit. This model differs from the model of perfect competition in one key respect: it assumes that the goods and services produced by firms are differentiated. This differentiation may occur by virtue of advertising, convenience of location, product quality, reputation of the seller, or other factors. Product differentiation gives firms producing a particular product some degree of price-setting or monopoly power. However, because of the availability of close substitutes, the price-setting power of monopolistically competitive firms is quite limited. Monopolistic competition is a model characterized by many firms producing similar but differentiated products in a market with easy entry and exit.
Restaurants are a monopolistically competitive sector; in most areas there are many firms, each is different, and entry and exit are very easy. Each restaurant has many close substitutes—these may include other restaurants, fast-food outlets, and the deli and frozen-food sections at local supermarkets. Other industries that engage in monopolistic competition include retail stores, barber and beauty shops, auto-repair shops, service stations, banks, and law and accounting firms.
Suppose a restaurant raises its prices slightly above those of similar restaurants with which it competes. Will it have any customers? Probably. Because the restaurant is different from other restaurants, some people will continue to patronize it. Within limits, then, the restaurant can set its own prices; it does not take the market prices as given. In fact, differentiated markets imply that the notion of a single “market price” is meaningless.
Because products in a monopolistically competitive industry are differentiated, firms face downward-sloping demand curves. Whenever a firm faces a downward-sloping demand curve, the graphical framework for monopoly can be used. In the short run, the model of monopolistic competition looks exactly like the model of monopoly. An important distinction between monopoly and monopolistic competition, however, emerges from the assumption of easy entry and exit. In monopolistic competition, entry will eliminate any economic profits in the long run. We begin with an analysis of the short run.
The Short Run
Because a monopolistically competitive firm faces a downward-sloping demand curve, its marginal revenue curve is a downward-sloping line that lies below the demand curve, as in the monopoly model. We can thus use the model of monopoly that we have already developed to analyze the choices of a monopsony in the short run.
Figure 11.1 “Short-Run Equilibrium in Monopolistic Competition” shows the demand, marginal revenue, marginal cost, and average total cost curves facing a monopolistically competitive firm, Mama’s Pizza. Mama’s competes with several other similar firms in a market in which entry and exit are relatively easy. Mama’s demand curve D1 is downward-sloping; even if Mama’s raises its prices above those of its competitors, it will still have some customers. Given the downward-sloping demand curve, Mama’s marginal revenue curve MR1 lies below demand. To sell more pizzas, Mama’s must lower its price, and that means its marginal revenue from additional pizzas will be less than price.
Given the marginal revenue curve MR and marginal cost curve MC, Mama’s will maximize profits by selling 2,150 pizzas per week. Mama’s demand curve tells us that it can sell that quantity at a price of $10.40. Looking at the average total cost curve ATC, we see that the firm’s cost per unit is $9.20. Its economic profit per unit is thus $1.20. Total economic profit, shown by the shaded rectangle, is $2,580 per week.
The Long Run
We see in Figure 11.1 “Short-Run Equilibrium in Monopolistic Competition” that Mama’s Pizza is earning an economic profit. If Mama’s experience is typical, then other firms in the market are also earning returns that exceed what their owners could be earning in some related activity. Positive economic profits will encourage new firms to enter Mama’s market.
As new firms enter, the availability of substitutes for Mama’s pizzas will increase, which will reduce the demand facing Mama’s Pizza and make the demand curve for Mama’s Pizza more elastic. Its demand curve will shift to the left. Any shift in a demand curve shifts the marginal revenue curve as well. New firms will continue to enter, shifting the demand curves for existing firms to the left, until pizza firms such as Mama’s no longer make an economic profit. The zero-profit solution occurs where Mama’s demand curve is tangent to its average total cost curve—at point A in Figure 11.2 “Monopolistic Competition in the Long Run”. Mama’s price will fall to $10 per pizza and its output will fall to 2,000 pizzas per week. Mama’s will just cover its opportunity costs, and thus earn zero economic profit. At any other price, the firm’s cost per unit would be greater than the price at which a pizza could be sold, and the firm would sustain an economic loss. Thus, the firm and the industry are in long-run equilibrium. There is no incentive for firms to either enter or leave the industry.
Had Mama’s Pizza and other similar restaurants been incurring economic losses, the process of moving to long-run equilibrium would work in reverse. Some firms would exit. With fewer substitutes available, the demand curve faced by each remaining firm would shift to the right. Price and output at each restaurant would rise. Exit would continue until the industry was in long-run equilibrium, with the typical firm earning zero economic profit.
Such comings and goings are typical of monopolistic competition. Because entry and exit are easy, favorable economic conditions in the industry encourage start-ups. New firms hope that they can differentiate their products enough to make a go of it. Some will; others will not. Competitors to Mama’s may try to improve the ambience, play different music, offer pizzas of different sizes and types. It might take a while for other restaurants to come up with just the right product to pull customers and profits away from Mama’s. But as long as Mama’s continues to earn economic profits, there will be incentives for other firms to try.
The term “monopolistic competition” is easy to confuse with the term “monopoly.” Remember, however, that the two models are characterized by quite different market conditions. A monopoly is a single firm with high barriers to entry. Monopolistic competition implies an industry with many firms, differentiated products, and easy entry and exit.
Why is the term monopolistic competition used to describe this type of market structure? The reason is that it bears some similarities to both perfect competition and to monopoly. Monopolistic competition is similar to perfect competition in that in both of these market structures many firms make up the industry and entry and exit are fairly easy. Monopolistic competition is similar to monopoly in that, like monopoly firms, monopolistically competitive firms have at least some discretion when it comes to setting prices. However, because monopolistically competitive firms produce goods that are close substitutes for those of rival firms, the degree of monopoly power that monopolistically competitive firms possess is very low.