Topic 4.1 - Individuals, firms, markets and market failure
Snapshot of the AQA syllabus topic area we’ll be covering in this post.
MONOPOLISTIC COMPETITION: Perfect competition, imperfectly competitive markets and monopoly
AQA students must understand the following content [taken from the syllabus]
The formal diagrammatic analysis of the monopolistically competitive model in the short and long run.
The main characteristics of monopolistically competitive markets.
Monopolistically competitive markets will be subject to non-price competition.
INFORMATION YOU NEED TO KNOW
[NOTE: supporting diagrams and questions at the end]
Introduction: Monopolistic Competition
A market structure known as monopolistic competition combines aspects of monopoly and competition. It is distinguished by a significant number of businesses offering distinctive products. In this set of study notes, we'll look at the monopolistically competitive model's formal diagrammatic analysis, its key features, and the idea of non-price competition.
The conditions of monopolistic competition are:
A degree of product differentiation
A degree of price making power
No or low barriers to entry
1. The Formal Diagrammatic Analysis of the Monopolistically Competitive Model:
Short Run [diagrams at the end of this page]:
- Due to product differentiation, firms in monopolistic competition face a downward-sloping demand curve in the short run.
Each company has some level of market strength, which enables them to determine their own prices.
- Companies produce where marginal revenue and marginal cost are equal in order to maximise profits.
- Economic profits or losses as well as excess capacity may be present in the short-run equilibrium.
In the long run: [diagrams at the end of this page]
- Because entry barriers are minimal, new businesses can enter the market.
- If existing businesses suffer losses, they can leave the market with barriers.
- Over time, customers may choose different companies as a result of product differentiation.
- Eventually, businesses engaged in monopolistic rivalry make normal profits.
- In the equilibrium, firms produce when the average total cost and demand are equal.
2. Characteristics of Monopolistically Competitive Markets:
- Large number of firms: The market hosts a large number of rival businesses.
- Differentiated products: Each company provides a product that is unique from those of its rivals in some way.
- Some market power: Because products are differentiated, companies have a degree of power in the market due to a unique selling proposition (USP)
- Independent choice: Each firm is free to determine its own price and output levels.
- Simple entry and exit: There aren't many barriers to entry - so businesses can enter or leave the market with minimal cost.
3. Non-Price Competition in Monopolistic Competition:
Monopolistically competitive businesses frequently engage in non-price competition to distinguish their goods and draw in customers.
- Marketing campaigns, advertising, product design, branding, and customer service are all examples of non-price competition.
- Companies concentrate on developing a unique selling proposition (USP) to set their product apart from rivals.
The objective is to increase brand loyalty and establish a perceived value for the product that goes beyond its cost.
Efficiency of a monopolistically competitive market
As the diagram shows, the firm is producing at the lowest AC, however, the price is above MC. Therefore, the firm is not allocatively efficient.
The firm also can produce at a point where ATC is not minimised (above the point MC=AC). This means the firm is not productively efficient.
The firms are smaller than monopoly firms - this means that they probably won't benefit from economies of scale.
The firm will likely not make large amount of supernormal profit for a very long time. Therefore, the firms will probably not be dynamically efficient.
Prices in a monopolistically competitive market vs other market structures
Whether or not the monopolistically competitive firm is inefficient, they will still probably achieve greater levels of efficiency than a monopoly overall.
Prices will be lower and output higher in this market when compared to a pure monopoly - therefore more wants and need are satisfied leading to a better allocation of resources (than a monopoly).
Compared to a competitive market, prices in a monopolistically competitive market should be higher overall. This is because the firm doesn't achieve levels of productive efficiency, so ATC is not minimised.
The more differentiated the products in the market, the greater the level of price setting power the firm has - this will result in an inelastic AR=D curve. Therefore, if products are more differentiated, prices will end up being higher.
This is why in the real world, firms strive to differentiate their products.
Conclusion
In conclusion, monopolistic competition combines aspects of monopoly and competition. In this market structure, businesses differentiate their goods in order to draw customers and exercise some kind of market control. However, because barriers to entry are low, the outcome is distinctly different from that of a monopoly or oligopoly firm.
Since companies in this industry place a strong emphasis on product differentiation through a variety of techniques, non-price competition is essential. Understanding the dynamics of this market structure requires an understanding of the formal diagrammatic analysis, features, and non-price competition in monopolistic competition.
To better understand monopolistic competition and its effects on the economy, keep in mind to look at case studies and real-world examples.
SUPPORTING DIAGRAMS
short run outcome of monopolistic competition - firms produce at MC=MR, the profit maximising level of output- firms make supernormal profits
long run outcome of monopolistic competition - firms produce at MC=MR, the profit maximising level of output - firms make normal profits - because barriers to entry are low, firms lose some of their price making power when new entrants join the market
SUPPORTING QUESTION
Question: Give 3 reasons why a local hairdressing firm is likely to be operating in a monopolistically competitive market.
Answer:
Differentiated Products: Hairdressing services frequently differ in terms of style methods, level of experience, level of client service, and environment. Each hair salon aspires to have a distinct brand and set itself apart from rivals. For instance, one salon might focus on cutting hair in innovative ways, while another might favour traditional forms. Due to the environment that is created by this product differentiation, monopolistic competition results in businesses providing similar but distinct services.
Some Degree of Market Power: Although a local hairdressing firm may not have significant market power compared to a monopoly, it still has some control over its pricing and product offerings. Hair salons can set their own prices based on factors like their reputation, quality of service, and customer demand. While they must consider the prevailing market prices and competition, they have more flexibility than firms in perfect competition.
Ease of Entry and Exit: The entry barriers to starting a hair salon are often not very high. Although some licences and permits might be necessary, newcomers to the sector can nonetheless enter it with little difficulty. A company can easily leave the market if it is unable to bring in clients or make money.
It's vital to remember that the local hair salon market could not entirely conform to the monopolistic competition model. Local laws, client loyalty, and geographic location are just a few examples of the variables that might affect a market's unique dynamics.