Pure Competition & Monopolistic Competition - Research Paper Example

Pure Competition & Monopolistic Competition: Analysis and Comparison 1. Introduction The concepts of pure and monopolistic competition in microeconomics act as a benchmark for various contemporary researches. A careful analysis would reveal that both pure competition and monopolistic competition bear various similarities and differences, having their own set of merits and demerits. However the prevailing differences between both systems indicate that monopolistic competition has a more realistic implication and inherent practicality in the marketplace. 2. Pure Competition Pure competition is one of the ideal benchmarks for analysis of current market. Where other market structures give autonomy to one of the parties i.e. buyers and sellers, perfect competition ensures that price remains the main determinant of the market dynamics. It is a complete opposite of monopoly where a single seller rules the market (Ayer and Collinge 20; Baumol and Blinder 32). There are various distinguished characteristics of pure competition that makes it highly distinguished from other market structures. In an ideal case, neither buyer nor seller has the capacity to influence market dynamics. 2.1 Market Characteristics A market is said to be exhibiting a perfect competition if: 1) There are large number of buyers and sellers. 2) Market constitutes of homogeneous products i.e. of similar nature and is substitutable. 3) Entry and exit of producers and sellers in the market is free and subjected to no obstacles. 4) Due to higher number of substitutes, the market price is a standard which sellers have to follow, making them unable of charging higher than market price. 5) Firms are usually price takers and have minimum influence over it (Robinson 105; Reynolds; Baumol and Blinder 33). 6) Information is available freely to buyers and sellers. 2.2 Firm in a Pure Competition in Short-Run A firm in a perfect competition shows complete elasticity to price fluctuations. Also, marginal revenues are equals to average revenues and market demands. It is the demand which causes shifts in average and marginal revenues in the short-run. Changes in market demand and supply leads to price fluctuations (Reynolds). 2.3 Profit Maximization in the Short-Run For a firm in a pure competition, the difference between total costs and total revenues represent profits. For a firm to earn maximum profits, ability to control and react to marginal costs and revenue functions is important. If a firm can identify the level where marginal costs (MC) can be equals to marginal revenues (MR), profit can be maximized by increasing the output and number of units sold. It is important to note that in a short-run, Average revenue (AR) is equals to marginal revenue (MR) which also represents market price. Furthermore, the firm is intended to increase profits and not revenues. Therefore, a firm is required to produce and sell additional goods in order to reduce marginal costs (MC). The lower marginal cost would lead to lower average costs and the difference between average costs and revenues would indicate final profits of the firm. In short, if marginal costs (MC) are equals to marginal revenues, the firm is earning maximum profits. In a scenario where these two variables are equal or MR is higher than MC, the firm should produce more and vice versa (see Fig 1). In a short-run, the maximum loss that a firm can bear is its fixed cost. Where a producer fails to yield revenues lower than variable costs, the firm should opt for production seize or shutdown since it is not even earning normal profits which would recover its variable costs and a portion of fixed costs. Therefore, in a short run, when firm is not making normal profits, the preferred strategy should be loss minimization i.e. recover variable costs (VC) at least (Reynolds). 2.4 Long-Run in Pure Competition In a long-run, the firm faces relative flexibility. Since it has potential of altering its production capacity, the choices governing firm’s entry, sustainability and exit face are subjected to cumulative responses of short-run demand and supply curves. In a long-run, the firm’s average costs (LRAC) is reflected by a combination of short-run average cost curves (SRAC). As the buyer has more substitutes, therefore price is the detrimental factor controlling demand and supply variables. The producers/ sellers have no ability to change or affect market price and their overall revenues are dependent on demand function which makes them a price taker. Entry or exit of major players will not alter market demand and supply since there are relatively large number of suppliers and substitutes available. Absence of market power makes the supplier dependent on buyers and market price (Reynolds). In a long-run, the firm is allowed to utilize maximum plant capacity or at least reduce cost per unit and earn normal profits. Anything higher or lower than market price would lead to the decision of business continuation or shut down in the long-run (See Fig 2). 2.5 Example One of the common examples would be dairy product vendors in a small locality who have similar product to offer with no specific differentiation. 3. Monopolistic Competition In a real life, perfect competition barely exists. There are various suppliers of homogeneous products that use different methods for attracting buyers and create virtual product differentiation i.e. through advertisement, price or free secondary products etc. Therefore, suppliers have a certain degree of superiority over competitors and buyers. A slightly different and more realistic form of pure competition is monopolistic competition. 3.1 Characteristics of a Firm in Monopolistic Competition In a monopolistic competition, 1) A firm is capable of making decisions dependent on variables other than price and demand. 2) Consumers and sellers share common knowledge. 3) there are no barriers to entry and exit 4) One o f the most significant features of this market structure is product differentiation. Firms use various techniques such as product outlook, product components, advertisement etc to produce physical and virtual differences in the substitutes. Therefore, they are not completely homogeneous irrespective of serving the same purpose (Monopolistic Competition). 5) The firm uses physical product, marketing, human capital skills and distribution differentiation to gain an edge over other market players (Hunt 174). 6) The suppliers are price makers since they have a potential of affecting the prices offered by them through product differentiation. Their demand also show inversely proportioned relationship with price resulting in downward sloping curve. 7) Larger firms with distinguished products exist (Chang 881; Case and Fair 58). 3.2 Firms in Monopolistic Competition in Short-Run Unlike perfect competition, monopolistic competition allows firms to have supernormal profits in short-run (Monopolistic Competition; Hunt 180). Due to product differentiation, the firm is able to attract more customers. Profits are maximized when marginal revenues (MR) are equals to marginal costs (MC). However, these supernormal profits are highly fluctuating and have an unpredictable nature. Due to aggressive marketing from existing players or entry of better suppliers, the profits can decrease to normal level again (See Fig 3). 3.3 Monopolistic Competition in the Long-Run Monopolistic competition in the long-run shows behavior rather similar to perfect competition. Due to availability of supernormal profits, many new suppliers may enter into the market. A cumulative outlook of short-run curves would show shift in demand curve resulting in normal profits which are a result of mitigation of supernormal profits with fewer losses and usual trend of regular profits (See Fig 4). Price differentiation and other product differentiation strategies along with lack of interdependence in suppliers and existence of selling costs in order to reach a particular segment and penetrate into the market, are some of the fundamental features of monopolistic competition. (Monopolistic Competition) 3.4 Example Food chain restaurants are a simple example. Where KFC and McDonalds both offer fast food, KFC specializes in chicken-based product whereas McDonalds deal with all kind of non-vegan products and vegetable burgers in countries like India. There is a clear product differentiation although the core product offered remained the same. 4. Similarities and Differences between Monopolistic and Pure Competition An overall outlook of monopolistic and pure competition show similarity since there are large number of buyers and suppliers, relatively homogeneous products, and no barriers to entry and exit. However, there are various distinguishable differences between these two forms of market structure which are given below: 1) In a monopolistic competition, a buyer is aware of the product in the name of branding however producers are relatively unknown or unimportant in a perfect competition. 2) Product homogeneity is a basic difference since in the monopolistic competition; products are differentiated through price or other factors. 3) Market price is the revenue that all suppliers will earn in perfect competition however monopolistic competition helps suppliers charge different prices due to product differentiation and consumer preference. 4) Firms are affected by each other’s products and prices in a perfect competition due to homogeneity. However, market intelligence and awareness about competitor’s strategy plays an important role in monopolistic competition. 5) Product quality remains same in pure competition whereas producers claim to vary it through product differentiation in monopolistic competition (Hunt 174). 6) Advertising is either industry or product-oriented in pure competition whereas suppliers focus on individual promotion in monopolistic competition. 7) In a pure competition, firm’s strategy is to survive and produce products at a lower cost. On the other hand, firms in monopolistic competition focus on increasing profits and acquire higher market share. 8) Marginal costs are the benchmark for firms in pure competition. On the other hand, individual profits and market share are the governing forces for suppliers in monopolistic competition (Pure Competition vs. Monopolistic Competition). 5. Advantages and Disadvantages 5.1 Pure Competition Pure competition act as a benchmark framework for other market structures. Such competition allows consumers to avoid exploitation in the name of differences that actually have no value addition. Similarly, it allows firms to gain better profits or normal profits at least. However, in reality, pure competition is difficult to be practiced. Suppliers usually attempt to increase profits by adopting various marketing strategies. Similarly, existence of perfect information and its availability to consumers and producers is also difficult to attain in reality. Furthermore, in practical world, barriers to entry are also present which is against the doctrines of this model. 5.2 Monopolistic Competition Monopolistic competition allows firms to enjoy relatively less or no barriers to entry. Due to product differentiation, consumers has better and diverse choices which offers them satisfaction and utility (Hunt 175). Market structure is better than monopoly since consumers and new entrants are not exploited in the hands of market leaders. Suppliers also have an opportunity to earn better profits. One of the disadvantages of this market structure is an absence of real product differentiation (Chang 879). The firm usually shows lesser efficiency in long-run however overall costs remain high due to marketing and product differentiation. This market structure is more realistic than pure competition although relatively inefficient since fixed costs remain high due to firm’s inability to produce up to optimum production capacity (Femminis 986; Monopolistic Competition). 6. Conclusion Pure competition and monopolistic competition are the fundamental economical concepts that provide foundation to micro and macroeconomics’ theoretical frameworks. Although the firms in both market structures have various similarities since products have relative homogeneity and suppliers have a choice of entering into and exiting from the market but product differentiation and business strategy of the firms in both kinds of market structures act as major distinguishable factors. Careful analysis would reveal that where both models have their merits and demerits but monopolistic competition is a more practical one in comparison. Works Cited Ayers, R., and Collinge, R. Microeconomics: Explore and Apply. Upper Saddle River, NJ: Pearson Prentice Hall, 2005. Print. Baumol, W.and Blinder, A. Microeconomics: Principles and Policy, 9th ed. Mason, OH: Thomson South-Western, 2005. Print. Case, K. and Fair, C. Principles of Microeconomics, 7th ed. Upper Saddle River, NJ: Pearson Prentice Hall, 2004. Print. Chang, Winston W. ‘Monopolistic Competition and Product Diversity: Review and Extension’. Journal of Economic Surveys 26.5 (2011): 879-910. Femminis, Gianluca. ‘Monopolistic competition, dynamic inefficiency and asset bubbles’. Journal of Economic Dynamics and Controls 26.6 (2002): 985-1007. Hunt, Shelby D. ‘The theory of monopolistic competition, marketing’s intellectual history and the product differentiation versus market segmentation controversy’. Journal of Macromarketing 31.1 (2011): 173-84. ‘Monopolistic Competition’. Economics Online. Web. 10 December 2012. ‘Pure Competition vs. Monopolistic Competition’. UAA Institute of Social and Economic Research, Web. 10 December 2012. Reynolds, Larry R. Alternative Microeconomics- Pure Competition. Bois State University. 2005. Web. 10 December 2012. Robinson, Joan. What is perfect competition? The Quarterly Journal of Economics 49.1 (1934): 104-120. Appendix A Figure 1 Source: Reynolds, Larry R. Alternative Microeconomics- Pure Competition. Bois State University. 2005. Web. 10 December 2012. Figure 2 Source: Reynolds, Larry R. Alternative Microeconomics- Pure Competition. Bois State University. 2005. Web. 10 December 2012. Figure 3 Source: ‘Monopolistic Competition’. Economics Online. Web. 10 December 2012. Figure 4 Source: ‘Monopolistic Competition’. Economics Online. Web. 10 December 2012. Read More