In a monopolistically competitive market, the products of different sellers are differentiated on the basis of brands. Product differentiation gives rise to an element of monopoly to the producer over the competing product. As such the producer of the competing brand can increase the price of his product knowing fully well that his brand-loyal customers are not going to leave him. This is possible only because the products have no perfect substitutes. Since however all the brands are of close substitutes to one another, the seller will lose some of his customers to his competitors.
Thus the market is a mix of monopolistic competition. There are three main features that distinguish between a perfect competition and monopoly market structure: the type of firm, the freedom of entry and the nature of the product (Sloman and Norris 1999, pg, 161). A table of these features is contained in Appendix A. These two market structures are on opposite ends of the scale and consequently, the features and benefits of each structure vary quite dramatically. In a perfectly competitive market structure, there must be many firms in the market competing for business.
In contrast to this, within a monopoly there is only one firm operating in the market. A firm that is operating within a perfect market is referred to as a price taker. Duffy (1993, pg. 107) explains that a condition of working within a perfectly competitive market is that “a price taker cannot control the price of the goods it sells; it simply takes the market price as given. ” In a monopoly, the firm does not have to take the given price. It is able to search the market for the best price to charge relative to the demand for the product, profitability and availability of the resources for manufacture.
This is particularly relevant when there is a shortage of supply. As there is only one seller of the product, consumers are forced to purchase the goods at a higher price. The International Encyclopedia of Economics (1997, pg. 1041) states, “that the monopolist can unilaterally dictate the quantity, quality, and price of the good or service it provides. ” This is in direct contrast to the fixed pricing structure of firms within a perfect competition market structure. Many variables can restrict entry to a market. There may be government regulations, patents, import/export restrictions or large investment and start up costs.
It is the number of restrictions in place that determines the difference between the two markets. There is no restriction on entering a perfect competition market. Sloman and Norris (1999, pg. 161) explain that there is complete freedom of entry for firms and established firms are unable to stop new firms entering the market. On the other hand, access to a monopoly is completely blocked or restricted. The access to a monopoly may be restricted for various reasons such as government regulations, legislation or initial set-up costs. Within a perfect market Duffy (1993, pg. 07) describes the products sold as homogeneous since there is no differentiation between what the firms sell. A consumer is able to purchase the same product for a similar price from numerous suppliers. In a monopoly, the product is unique in that any other company does not supply that good in a similar fashion. The nature of the product is more to the monopolist’s advantage than that of the companies within a perfectly competitive market structure. A monopolist has significant control over the services or products its provides due to the lack of competition.
Due to the unique nature of the product a company provides, the monopolist is able to restrict the goods it supplies thereby increasing the price charged and the profit made. This is in direct contrast to a firm operating within a perfect competition market structure. Long run equilibrium In the long run, all monopolistically competitive firms earn only normal profit. The reason for this can be explained by the help of an diagram. The move from short run to long run is very similar to perfect competition. The reason for this is that the assumption about barriers is the same.
There are no barriers to entry or exit. This means that new firms will be attracted by any super normal profit. The addition of new, slightly different, products onto the market will mean that all existing firms will find their demand curves shift slightly to the left. This will keep happening as long as firms keep entering (AR1 moves towards AR2). Firms will keep entering while there is super normal profit to take advantage of. This process will stop once all firms in the industry are earning only normal profit.
The lines AR1 and MR1 are the short run revenue curves. As explained above, the additional products that are introduced onto the market by new firms cause every existing firm’s demand curve to shift to the left until every firm earns only normal profits. So AR1 shifts to AR2, with the corresponding MR curves shifting with them. At this point, AR = AC and only normal profit is being earned. There is no incentive for any firm to enter or leave the industry. We have a state of rest, or equilibrium. The situation is the same when firms are making a loss in the short run.
Firms cannot sustain losses into the long run, so some of the existing firms decide to leave no barriers to exit. This will cause the demand curve for each firm that stays to shift to the right, as they now have less competition. This is illustrated by the shift of the green AR curve (AR1)to the right until it reaches the black AR curve (AR2). At this point there will be no incentive for any firm to enter or leave the industry. We have a state of rest, or equilibrium. This one is about barriers to entry. We assume that there is total freedom of entry into and exit from the market.
There are no barriers to entry or exit (just like perfect competition). In a monopolistically competitive market, it is assumed that both buyers and sellers have perfect knowledge, about prices in particular. Buyers and sellers know the exact price of the product charged by all firms at all times. This means that there are no search costs for consumers (searching for the best price). Again, this is the same as for perfect competition. This is the big difference between monopolistic competition and perfect competition.
Whereas in perfect competition, the product sold by the numerous firms in the market is homogenous, in monopolistic competition the products offered are similar but differentiated, or non-homogenous. All firms aim to maximise their profits. That is their sole objective. Buyers aim to maximise their welfare through their purchases (the same as with perfect competition). It is assumed that all of the factors of production are perfectly mobile. If they are not being used as efficiently as they could, they will instantly move to where they will be best used without any restrictions.
Again, the same as perfect competition. Unlike firms in perfectly competitive markets, monopolistically competitive firms do have a small amount of control over the price they charge. Their demand curve is not perfectly elastic, but it is relatively elastic. In other words, the demand curve is very flat, but not horizontal. Remember that the products are slightly different, but basically very similar. This means that each firm faces a lot of substitutes, so the elasticity of demand is very high.
Short run. The diagram above shows a firm in a monopolistically competitive industry making super normal profits in the short run. The diagram is exactly the same as the one for the monopolist; the firm maximizes profit by setting MC = MR giving price P1 and quantity Q1. The one difference is that that the AR (the demand curve) and MR curves are much flatter. Remember that monopolistically competitive firms face a lot of competition and, therefore, the demand for their product is very elastic. The firms are not price takers, but they do have very little power.