Monopolistic Competition
- Source: Ch. 13 Section 13.B pp. 465-469.
- Monopolistic competition: A market structure where firms in the industry
produce products that are close substitutes for one another.
- Each firm has monopoly power over its own unique variant of the product.
- Each firm competes for market share with industry rivals producing similar
products.
- Classic (Chamberlin) version assumes free entry.
- What is an industry here?
- producers of similar products, e.g., brands of soft drink, soap,
breakfast cereal, cars, etc.
- Differentiated products: how and why do they differ?
- individual consumer preferences differ over product characteristics
e.g. appearance, taste, etc.
- Firms create a variety that appeals to a certain clientele.
- advertising may make consumers view similar goods differently.
(are there other actions businesses can take to make consumers
view similar or identical goods differently?)
- fashion or fads: can collective preferences create differentiation?
Chamberlin’s Model of Monopolistic Competition:
- Key assumptions of the model:
(1) firms in an industry produce heterogeneous (differentiated)
products: each firm is a price maker for its variant of the good;
- vs. perfect competition: identical products.
- some monopoly power over own variety.
(2) firms do not behave strategically: each ignores the effects of its
actions on its competitors.
- chooses output and sets price assuming this choice has
no effect on competitors choice.
- this is easiest to defend if firms in the model are small
compared to the industry (as in perfect competition)
(3) entry of new firms is relatively costless;
- like perfect competition unlike monopoly.
(4) buyers are small (price takers).
- Endogenous variables: prices, quantities, number of firms and varieties
(long-run).
- Exogenous variables: determinants of demand and costs.
- Individual Firm’s Demand curve in Monopolistic Competition:
- downward sloping:
- high price: only those with a strong preference
for your variant of the product buy it.
- low price: those with a strong preference for your variant still
buy, but so do others who substitute your (cheap) product for otherwise preferable variants.
- this holds prices of similar products produced by other firms
constant
(demand is less elastic if prices of all similar
products change simultaneously see DD).
(Text: “DD” curve – shows how demand changes if all firms change prices simultaneously .
- DD steeper: less substitution as prices for all varieties change
simultaneously.
- Useful for thinking about how “collusion” outcome differs and for
thinking about efficiency of the outcome. )
- Demand curve is also affected by the number of monopolistic
competitors.
- more competitors:
- demand likely more elastic (more close substitutes)
- demand shifts left (smaller market share at any
given price).
- Short-run:
- Act like a monopolist: produce at output where MR = MC.
- Say that at this outcome: Price > ATC (economic profit made).
- Price is also a markup over MC (like monopoly).
- Long-run:
- Entry occurs in response to short-run profits.
- Entry here means new firms producing new varieties of the good.
- Demand for each existing firm shifts left and becomes flatter.
- output at which MR = MC shrinks.
- Entry continues until profits are eliminated.
- at this point demand for each firm has shifted left to the point
where it is tangent to the ATC curve and where MR=MC
at this output.
- if the heterogenous goods are very close substitutes: outcome
almost identical to perfect competition.
i.e., since demand curve is nearly flat.
- Flatter (more elastic) demand in long-run means price markup may
be small.
- Evaluating the monopolistically competitive outcome?
- long-run outcome: tangent to downward sloping part of the long-run
ATC curve.
- firms are “too small”: they produce less than their minimum
efficient scale (MES).
(MES: output level at which LRAC is at its minimum)
- efficiency loss: produces where MR = MC not where P=MC.
- But is there an offsetting benefit to monopolistic competition?
- consumers may value variety:
- having heterogeneous products can increase consumer
surplus;
- if so it is unclear whether having fewer, larger scale firms but
less variety makes society better off.
- What if the consumer preference for a new variant is created
by advertising?
- is there really any benefit to variety then?
- important question: welfare economics assumes
preferences are not created by
economic decisions.
- how to judge economic outcomes if preferences
are created?
(“customer loyalty” schemes e.g. frequent flier points –
do they make issuer’s profit different to some
buyers? – similar issues to advertising)
Importance of Monopolistic Competition:
- Provides a way of thinking about product diversity, why it arises and its
pros and cons.
- A version of the model can be solved for a general equilibrium (across all
markets simultaneously): unusual for non-competitive market structures.
- Dixit-Stiglitz Model: widely used in international trade, growth,
location and macroeconomic literatures.
- Can combine this structure with oligopoly models.
For example: a hybrid
- Differentiated products (like monopolistic competition (M.C.) unlike
oligopoly)
- Demand curves of firms interdependent (true in both M.C. and olig.)
- Restricted entry: like oligopoly, unlike M.C. e.g. say two firms.
- Can build a Cournot or Bertrand style model by allowing output or
pricing decisions of firm producing one variety to affect the demand curve of a firm producing another variety.
(time permitting: could do Bertrand with differentiated products – more interesting reaction functions than when products are identical e.g. see Perloff’s Coke-Pepsi example)
Locational Models as Versions of Monopolistic Competition:
- Monopolistic competitors:
- products are differentiated – imperfect substitutes.
- products differ in some way that matters to consumer.
- Usually think of this in terms of different product characteristics:
- taste of the soft-drink, style of shirt or car, etc.
- another way in which products differ between different firms is in
location of the firm providing the product.
- model in Ch. 13, pp. 469-478: identical physical product but sold at
different locations.
- In this case products differ in a readily measurable way:
- distance from the consumer ;
- dollar equivalent: transportation costs of obtaining the
product.
Hotelling’s Model of Firm Location (Ice Cream/Hot Dog Vendor Model):
- See text (Ch. 13, p. 476)
- A classic example:
- location problem given location of consumers.
- choice of location determines market share: given distribution of
customers.
- Uniform distribution of customers along a beach:
- demand fixed at 1 each, price $1 per ice cream cone.
- Customers go to the closest vendor (minimize transport costs)
- Preferred location?
- One vendor: any location on the beach.
- Two vendors:
- Consider locations ¼ and ¾ along the beach.
- Each vendor serves ½ of the beach (market area).
- Is this an equilibrium? No!
- Say one vendor is mobile:
- moves toward the other firm: expands market area.
- best location: adjacent to competitor.
- Now let both firms move: leapfrog to the center.
- Equilibrium:
- Firms adjacent in the center of the market.
- Interesting point: inefficient from view of
transport costs.
- More generally: median location result.
- assume customers are not uniformly distributed but
more concentrated at some points than other.
- firms will move to the median location: 50% of the market on
either side.
- How general is the result?
- Three vendors: no equilibrium!
(oddly with other numbers there generally is).
- Allowing for price competition and location choice: no
simple equilibrium outcome.
Hotelling’s Model and Product Differentiation
- Consumers differ by location in Hotelling’s model.
- Imagine they differ by tastes for some characteristic of a good and that
differences in taste can be represented as points along a line.
- Can get Hotelling-like clustering:
- firms decide on the type of good (point on the line) in order to
capture customers closest in taste to that type.
- tendency to produce similar goods results: just like in the location
model firms locate near each other.
- does this mean there is too little variety?
- but what if product differentiation is created by advertising? Does
that mean there is too much variety?
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