TOPIC 9 ► MONOPOLISTIC MARKET

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Describe the characteristics of a monopolistic market;
2. Differentiate a monopolistic market, perfectly competitive market and the monopoly market;
3. Assess the short-run equilibrium of a firm, and the long-run equilibrium of a firm; and
4. Analyse the social costs that exist in the monopolistic market.

INTRODUCTION

In the previous discussions, we have understood how two market structures having contrasting features or characteristics (the perfectly competitive market and monopoly) operate in the market. Now you are ready to learn about a type of market structure that has a combination of characteristics of the perfectly competitive market and the monopoly market, and this market structure is known as the monopolistic market.

9.1 THE CHARACTERISTICS OF A MONOPOLISTIC MARKET

SELF-CHECK 9.1

The monopolistic competition market is a market that has quite a large number of firms, producing a variety of goods which are close substitutes of each other. Can you list  some examples of goods or services based on the characteristics of the monopolistic market?

Let us look at the characteristics of a monopolistic market. A market is classified as a monopolistic market when it has the following characteristics:

1. A large number of sellers;
2. Unrestricted freedom of leaving or entering market; and
3. Different kinds of goods.

9.1.1 A Large Number of Sellers

There are many sellers in a monopolistic market but not as many as in a perfectly competitive market. This means that the product of each firm is relatively small compared to the market product.

9.1.2 Unrestricted Freedom of Leaving or Entering Market

Firms have the freedom to leave or enter market as with firms in a perfectly competitive market. The effect is that the number of firms in the industry is coordinated until all firms in the market gain normal profit.

9.1.3 Goods that can be Differentiated

In a perfectly competitive market, the goods produced are homogenous. In reality however, most goods have close substitutes, but not perfect substitutes. Therefore, goods produced by firms in a monopolistic competition market can be differentiated. Among the differences are as shown in Figure 9.1.

Figure 9.1: Differences of goods produced

SELF-CHECK 9.2

Try to give a few examples of monopolistic competition. Seek help from your friends or browse websites in order to obtain more information.

9.2 DEMAND, AVERAGE REVENUE AND MARGINAL REVENUE

In order to study how price and output that maximises profit are determined in a monopolistic competition, firstly we have to identify the demand curve faced by each firm.

9.2.1 Goods that can be Differentiated and Elasticity of Demand

Every firm in a monopolistic competition sells goods that can be differentiated by consumers and do not have perfect substitutes. Why is this so? This is the source of power for firms to determine the price level of their goods. Therefore, the firm will have a demand curve that is negatively sloping from left to right as with firms in the monopoly market.
However, the power to determine price is not as large as the power possessed by a monopoly firm because the goods produced have close substitutes. Since the power to determine price is less, hence the firm will have a more elastic demand curve compared to the demand curve of a monopoly firm. In other words, a monopolistic firm has a demand curve that slopes downward from left to right which is more elastic compared to the demand curve of a monopoly.
The demand curve is also the average revenue curve of the monopolistic competition firm. Its marginal revenue curve is a curve that slopes downwards from left to right and the gradient is twice the gradient of the demand curve.

9.3 SHORT-RUN EQUILIBRIUM OF FIRM

From the discussion, we know that the firm has a demand curve with a negative gradient from left to right because the firm is able to control price. This means the marginal revenue curve (MR) is the curve situated below the demand curve and crosses the horizontal axis at the middle point between the origin and the point where the demand curve intersects the horizontal axis.
In the short-run, a monopolistic competition firm acts similarly to a monopoly firm. Here, we find that a monopolistic competition firm maximises its profit (or minimises its loss) in the short-run by producing an output at the level where marginal revenue is equivalent to marginal costs (MR = MC). For further explanation, let us look at Figure 9.2.

Figure 9.2: Monopolistic competition firm and supernormal profit in short-run

Figure 9.2 illustrates the costs curve, demand curve and marginal revenue curve of a firm in a monopolistic competition market. In order to maximise profit, the firm fulfills the rule MR = MC, that is at point e, and produces q units of output and imposes price P for each unit.
We find that the average costs curve is situated below the demand curve. This means the firm enjoys supernormal profit as denoted by the shaded area. However, there is no guarantee for a firm in a monopolistic competition to gain supernormal profit in the short-run.
Even though the firm is able to control price, the factor of market demand is not enough to enable the firm to gain a supernormal profit. Therefore, we will look at the condition of the firm having the same costs curve but faces a weak market demand.

9.3.1 Monopolistic Competition Firm and Subnormal Profit in Short-Run

Now we will look at a monopolistic firm and subnormal profit as shown in Figure 9.3.

Figure 9.3: Monopolistic competition firm and subnormal profit in short-run

Figure 9.3 illustrates the condition where a monopolistic competition firm faces subnormal profit in the short-run. The firm produces output when MR = MC, that is at point e. The firm will minimise loss by producing q units of output and imposing a price of P. The firm’s loss is denoted by the shaded area.
In a certain condition, the firm must determine whether to continue with production operations or not. Here, the firm will use the same rule as used by firms in a perfect competition and monopoly market. The rule is that, as long as the price is at or above the average variable cost curve, the firm will produce output in short-run. If the price can no longer accommodate variable costs, the firm will close down its operations.

9.4 EQUILBRIUM IN THE LONG-RUN

In the discussion above, we find that maximisation of profit in the short-run for firms in a monopolistic competition is similar to monopoly firms. However, the situation is different in the long-run. This is because firms in a monopolistic competition can effortlessly exit from and enter into the industry depending on the condition of profit enjoyed by firms already present in the industry.
In the long-run, supernormal profit enjoyed by the firms existing in the industry will attract new firms to enter the industry. Since new firms supply goods that are similar to the goods supplied by the existing firms, the number of consumers for the existing firm will decline because part of their consumers have moved to the new firms.
In other words, the entry of new firms causes the market share of the existing firms to decline. This condition is shown by the downwards movement of the demand curve as in Figure 9.4. As more new firms enter the market, hence the smaller the market shares of the existing firms. This means the demand curve will further shift downwards.
This process will stop when there are no more new firms entering the industry, that is, the condition where demand curve touches the average costs curve and the firm only gains normal profit.
Figure 9.4 illustrates the coordination that takes place in the long-run for a monopolistic competition firm. In order to maximise profit, the firm produces q unit of output and imposes a price of P. Curve D₁ and MR₁ represents the short-run demand and marginal revenue. The firm gains positive supernormal economic profit because the average costs curve is below the demand curve.
In the long-run, positive economic profit will attract new firms to enter the industry. These new firms will produce goods that are close substitutes for goods produced by the existing firms. The entry of new firms will cause the market shares of existing firms to diminish, and this is indicated by the downward shift of the demand curve, from D₁ to D₂, where a long-run equilibrium is achieved. The shift of demand curve is followed by the shift of the marginal revenue curve from MR₁ to MR₂.

Figure 9.4: The effect of new firms’ entry into the monopolistic competition industry

What will happen now? Long-run equilibrium is achieved when new firms realise that there are no more incentives to enter the market, while existing firms realise that there are no more excuses to leave the market, that is, at the level of normal profit. Figure 9.4 illustrates the long-run equilibrium of a monopolistic competition firm. Figure 9.5 is the result of the shifts that occurred in Figure 9.4.

Figure 9.5:Long-run equilibrium of monopolistic competition firm

From Figure 9.5, long-run equilibrium is achieved when each firm produces q₂ units of output and imposes a price of P₂ after fulfilling the rule of MR = MC. The price imposed by the firm at P₂ is equivalent to the average cost.
This means every firm will only gain normal profit. Here, the long-run equilibrium occurs when the new firms enter the industry and reduces the demand curve until the curve touches the average costs curve as denoted by point A.
If the firm faces a loss in the short-run, coordination in the long-run will take place when there are firms that leave the industry resulting in the increase in market shares of existing firms.
Therefore, the demand curve will shift upwards until the industry achieves long-run equilibrium, that is, when all firms only gain normal profit. In the end, all firms will be in the state of long-run equilibrium, as depicted by Figure 9.5.

9.5 SOCIAL COSTS IN MONOPOLISTIC MARKET

In Topic 7, we know that economic efficiency is achieved when P = MC = minimum AC. Distributive efficiency is achieved when P = MC and productive efficiency is achieved when P = minimum AC.
Since a monopolistic competition market is a combination of characteristics of the perfectly competitive market and the monopoly market, it is reasonable to consider whether it is an efficient market structure such as the perfectly competitive market, or inefficient as the monopoly market. Analysis will be made based on Figure 9.6.

Figure 9.6: Inefficiency in monopolistic competition market

Figure 9.6 indicates a monopolistic competition firm in a long-run equilibrium. We find the firm operating at point A, which is the declining section of the average costs curve. In order to achieve production efficiency, the firm should be operating at point B, that is, the minimum point of the average costs curve. This means that at point A, the firm faces a higher average cost per unit compared to point B.
On the other hand, a perfect competition firm is in the state of long-run equilibrium when it operates at the minimum point of the long-run average costs curve (point B). Since the monopolistic competition firm does not operate at the minimum point of the AC curve, we find that output produced at point A is lower compared to production at point B.
Failure of the firm to operate at point B will result in capacity surplus, that is, the difference between output level at the minimum point of average costs curve with the output level that maximises the firm’s profit.
Based on Figure 9.6, the monopolistic competition firm is not producing at P = MC (point T) in order to achieve distributive efficiency. At the output level that maximises profit, Q, it is found that price (AQ) exceeds the marginal cost (CQ). As the discussion in the case of a monopoly, the consequence is the existence of social costs as denoted by the area ABT which is referred to as deadweight loss.

9.5.1 Monopolistic Competition and Consumer Welfare

From the discussion above and Figure 9.6 earlier, it is clear that a monopolistic competition firm does not achieve economic efficiency. In fact, production at the level that maximises profit had resulted in capacity surplus and deadweight loss to the society. The question is, can policy makers fix this condition?
One of the sources of inefficiency is price at the output level that maximises profit exceeds marginal costs. If the government imposes the rule that the firms must produce at P = MC to eliminate deadweight loss, do you think it will work?
In the long-run, a monopolistic competition firm will only gain normal profit. If the government forces a firm to reduce their price until it is equivalent to the marginal cost (point T), the firm will experience a loss because point T is situated below the AC curve. This will result in the shut down of the firm’s operation in the long-run, because the firm faces the condition of P less than AC.
If all firms shut down their operations, this means there are no more firms to supply goods that can be differentiated. In other words, there will only be homogenous goods and no close substitutes in the market.
Besides that, the deadweight loss which exists in the monopolistic competition market is not as large as the deadweight loss in the monopoly market. This is because the demand curve of a monopolistic competition firm is more elastic compared to the demand curve of a monopoly firm.
The same applies if the firm is forced to produce at the minimum point of AC curve in order to eliminate capacity surplus, that is, at point B. In Figure 9.6, we find that the firm will experience loss because the average cost is much higher than price. In the long-run, the firm has to shut down its operation if it is facing loss in order to avoid bigger losses.
In conclusion, the production of differentiated goods by monopolistic competition firms is the exchange for the inefficiency that exists in a monopolistic competition. Consumers have to pay a higher price to obtain goods that can fulfil their preferences besides being able to diversify their choices.

ACTIVITY 9.1

Describe how a monopolistic competition market is different from a perfectly competitive market and monopoly market.

SUMMARY

• In short, the understanding towards market structure of the perfect competition and monopoly is very useful in studying the behaviour of firms in a monopolistic competition.
• What is important is how you are able to look at the role of differentiated goods in influencing the shape of the demand curve, average revenue curve and marginal revenue curve.
• From there, you are able to understand the reasons why firms in a monopolistic competition can act like a monopoly in determining price and output.
• Even though the firm has the power to determine price, it is not able to maintain profit in the long-run since there are many producers.
• Besides that, there are no barriers to entry or exit for firms in the market, which finally will lead to firms gaining only normal profit in the long-run.
• Furthermore, you have looked at the social costs that exist in the monopolistic competition structure. We find that the firm does not achieve economic efficiency.
• The most prominent issue in the discussion about this market structure is that it results in capacity surplus. We have also discussed the advantages and disadvantages if we try to eliminate them.