Forms of Monopolistic Competition - Essay Example

MONOPOLISTIC COMPETITION by Question Monopolistic Competition Different forms of competition especially in the business sector characterize the world. Competition is an important aspect of business because it forces companies to be innovative and come up with products and services that can compete with other products and services in the market so that they can be sold and attract the required profits. Monopolistic competition is a form of imperfect competition that characterizes the business world and can be found in different sectors and industries. It is a common form of industry structure with a large number of organizations with some amount of market power. This paper discusses the concept of monopolistic competition using a variety of theories and real data. It also presents an existing case where specific aspects of monopolistic competition can be highlighted. Monopolistic competition refers to a market characterized by many firms that offer similar products but not identical. The products and services can be considered as substitutes but not complete identical to each other. This aspect means that the cross-price elasticity of demand is huge but not infinite. The firms in this kind of competition can enter the market freely as well as exit freely when they please. It is effortless for new organizations to enter the market with own brands. Similarly, firms that have been in the market for long can also leave when their products become unprofitable (Morton & Goodman, 2003:203). Monopolistic competition is like a monopoly because the organizations in this market have a downward-sloping demand curve meaning that the prices exceed the marginal cost. Organizations that exist in monopolistic competition markets have similar rules to monopolies in terms of profit maximization. They choose the output level where the marginal cost and the marginal revenue are similar and they set their prices by looking at the demand curve so that the goods produced must be bought by the customers (Zhelobodko, Kokovin, Parenti & Thisse, 2012:2765) There are different theories that explain monopolistic competition. First, the Krugman model (1980) offers a formal description of the profits gained from a particular form of trade in the absence of comparative advantage (Bertoleti & Etro, 2014: 459). This model was branded a new trade theory because it influenced a lot of research on trade and industrial organization between the 1980s and 1990s. The Krugman model explains that product differentiation at the firm level leads to monopolistic competition because such competition comes about when there is some degree of change in the number of varieties of process manufactured. This represents the entry or exit of particular products in the market. Despite the fact that the model does not represent the entry or exit of firms in the market, it represents the entry and exit of products. The profits gained from this are purely demand-side variety gains because products are produced based on the available demand in the market. Therefore, a firm that applies the Krugman model attracts gains from new varieties of products that did not exist in the market. New products could mean modification of earlier products that existed (Bertoletti & Etro, 2014: 459). The theory of monopolistic competition (1933) by Edward Hastings Chamberlin argues that the consideration of monopoly and competition as alternatives is wrong because the two concepts are mostly combined. Chamberlin begins with the monopoly by stating that it occurs on a scale of substitution of products (Bellante, 2011:17). He states that an organization that has a significantly different product from other products has a monopoly over it but subject to the competition that the substitute products provide. Therefore, each firm in an industry has some form of monopoly on its own product. When there are two sellers with similar products, the resulting situation is duopoly whereas a situation with more than two producers is considered an oligopoly. Chamberlin’s main idea on monopolistic competition centres on the product. In monopolistic competition, therefore, each producer faces competition from substitute products because they limit a firm’s monopoly over its own product. Therefore, to Chamberlin, a monopolistic competition has differences in price policies, sales efforts and nature of products (Bellante, 2011:20). The Melitz (2003) heterogeneous-firms model explains monopolistic competition by considering a world of asymmetric countries where the industry is populated by firms only differentiated by the varieties of products that they produce as well as their productivity mechanisms (Melitz, M. J., & Redding, S. J., 2012:2). Firms are not assured of their future productivity when they make a decision to enter a domestic market. However, these firms apply different productivity levels facing fixed production costs that increase the returns to productivity scale. Therefore, inefficient organizations are forced out of the market when their productivity goes lower than the threshold level because there is no assurance of future profits. Each organization is a monopoly for the varieties of products it comes up with and sets prices for those products at constant mark-ups over the marginal cost (Melitz & Redding, 2012:2). Looking at the above theories, it is important to note that monopolistic competition describes markets that have many companies that sell products and services that are similar but with slight difference giving these companies a competitive advantage over their products, also considered as monopoly. A perfect competition is characterized by customers who are indifferent to the products of competing firms. However, a monopoly exists where a product does not have close substitutes. Between a perfect competition and a monopoly, there is a market that has products having substitutes that are close but not perfectly similar (Morton & Goodman, 2003:204). In such a market, consumers are willing to pay more for a particular product but when the price is largely different, the consumers choose a substitute product. This market best explains monopolistic competition where firms have some form of monopoly but not assured. In monopolistic markets, firms make profits by convincing customers that their products are the best though a process of product differentiation. Here, organizations offer products that are similar but are imperfect substitutes for the products manufactured by competitors. Product differentiation does not mean that a firm must engage in a genuine innovative process as long as it manages to convince customers that the products provided are unique. In monopolistic competition, product differentiation is achieved through branding and advertising (Boland, Crespi, Silva & Xia, 2012). This aspect has to be done to guarantee that customers believe that the product is different from the others, even when it is actually not. The main purpose is to make the customers pay for a particular brand and not any other. The graph below shows characteristics of monopolistic competition. In the above graph, the steepness of the demand curve is determined by the degree of suitability of a firm against its competitors. When buyers see products from different firms as close substitutes, they are bound to choose products from one firm if either of them raises the prices of its products. Here, the demand curve becomes flat. However, when customers are loyal to one firm, they will not stop buying its products even when prices are increased unless the increase is too large. Here, the demand curve becomes steeper. This aspect means that when products are less differentiated, the organization’s demand curve goes closer to the horizontal curve that is faced by perfectly competitive firms. However, when differentiation is increased, the steepness of the demand curve increases because it shows that the products of the firm are selling highly in the market. It is also important to note that the demand for a particular firm’s products in monopolistic competition is not always assured (Zhelobodko, Kokovin, Parenti & Thisse, 2012:2767) When the average total cost is under the market price, firms that operate in monopolistic competition earn huge economic profits. However, when the average total cost is above the market price, the organization operating in monopolistic competition incurs losses and has to exit from the market. This factor is clearly captured in the graph below. Here the short-run loss is calculated as follows: Short-Run Loss = (ATC - Price) × Quantity Monopolistic competition is characterized by a long-run equilibrium. When competitive firms earn a lot of profits in a market, other organizations join the industry and reduce the profits earned by the existing firms. This entrance will increase until the existing firms earn a normal profit. However, the entry of too many firms into the market makes inefficient companies exit the market. The efficient companies will remain and return to profitability providing the long-run equilibrium that helps encourage monopolistic competition. This factor makes the market price similar to the average total cost. In this scenario, the marginal cost and the marginal revenue are the same (Zhelobodko, Kokovin, Parenti & Thisse, 2012:2765). This is clearly captured in the graph below. Companies operating in monopolistic competition do not operate using the minimum average total cost meaning that they operate under excess capacity. It is also vital to note that organizations in monopolistic competition not only depend on their competitive edge, but also other factors that affect the amount of profits they make and for how long they do. For example, strategic positioning in the market of a firm compared to competitors will always give the firm competitive advantage even when other firms enter the same market to create more competition. In this case, a firm that is strategically positioned has a market power over the other companies in a monopolistic competition (Morton & Goodman, 2003:203). A real case highlighting specific aspects of Monopolistic competition In the United States of America, the toothpaste industry represents a monopolistic competition. The U.S. has over 50 firms that manufacture toothpaste. The market has been hit by an explosion of specialized toothpaste and gels that all claim to have powers to whiten teeth, curb sensitivity, reduce plaque and fight gingivitis. The companies package these toothpaste and gels in all manner of flavors, sizes and designs. This market has always been characterized by rising prices. For example in 2010, 69 new toothpaste were introduced to the market. The competition has gone a notch high because many companies enter the market. The packaging of toothpaste into different designs, sizes and shapes has clearly captured the aspect of product differentiation. The competition has been too high that some companies have decided to scale down. For example, Procter & Gamble Co., decided to reduce the number of oral-care products in the market from the year 2009 because it considered this move to be better. Other stores have also made decisions to simplify. For instance, in 2010, 352 types of toothpaste were sold at retail compared to 412 that were sold in 2008. This aspect shows that some companies decided either not to produce or to scale down. The firms that decided to scale down or stop production were operating with an average total cost that was above the market price, thereby incurring losses. Responding to the reasons as to why it had to cap the number of package sizes and flavor versions in its stores, Supervalu Inc’s director of personal care John Mullaney stated, “heres so much variety now that it has gotten a little daunting for shoppers” (Byron, 2011). This statement shows the large number of firms in the toothpaste market. It also confirms that these firms produce the same product but differentiate them to achieve some form of monopoly over their products in the market, which was mainly done through branding. In 1950s and 1960s, there were a few toothpaste companies in the U.S., such as Crest. At the same time, toothpaste was taken from the cosmetic group to the therapeutic status. The sales of a company such as Crest tripled over the next couple of years and attracted many other companies to the market because of the high profits. However, by 2010, the number of companies had increased to the extent that the profits realized in the industry was too low that it forced some companies to close and others to cut down spending on the production of toothpastes. The strong brands such as Crest and Colgate control 70 percent of the market showing that they managed to create loyalty among consumers. When customers do not find the brands at a particular store, they move elsewhere to look for them. This aspect shows how Crest and Colgate’s brands are performing in the toothpaste industry as an example of monopolistic competition (Byron, 2011). Reference List Bellante, D., 2011. Edward Chamberlin: monopolistic competition and Pareto optimality. Journal of Business & Economics Research (JBER), 2(4). Bertoletti, P., & Etro, F., 2014. Pricing to market in the Krugman model. Economics Bulletin, 34(1), 459-68. Boland, M. A., Crespi, J. M., Silva, J., & Xia, T., 2012. Measuring the benefits to advertising under monopolistic competition. Journal of Agricultural and Resource Economics, 37(1), 145. Byron, E., 2011. So Many Toothpastes: Manufacturers and Stores Limit New Introductions - WSJ. Retrieved from http://www.wsj.com/articles/SB10001424052748703373404576148363319407354 Morton, J. S., & Goodman, R. J. B., 2003. Advanced placement economics: Macroeconomics: student activities. New York, N.Y: National Council on Economic Education. Melitz, M. J., & Redding, S. J., 2012. Heterogeneous firms and trade (No. w18652). National Bureau of Economic Research. Zhelobodko, E., Kokovin, S., Parenti, M., & Thisse, J. F., 2012. Monopolistic competition: Beyond the constant elasticity of substitution. Econometrica, 80(6), 2765-2784. Read More