MonopolisticCompetition

IBEconomics:TheoryoftheFirm&MarketStructures

BasicsofMonopolisticCompetition

• Monopolisticcompetitionisaformofimperfectcompetition andcanbefoundinmanyrealworldmarketsrangingfromsandwichbarsandcoffeestoresinabusytowncentretopizzadeliverybusinessesinacityorhairdressersinalocalarea.• Carehomesforolderpeoplemightalsofitintothemarketstructureknownasmonopolisticcompetition• Monopolisticcompetitionissimilartoperfectcompetition,indeedsomeeconomistsregarditasmorerealistic,becausetheproductsaredifferentiated• Productdifferentiationmeansthatbusinesseshavesomecontrolovertheirproducts,itimpliesthatfirmshavesomeprice-settingpower,ARslopesdownwards

ExamplesofMonopolisticCompetition

Shoerepairsandkeymakers

Taxiandminibuscompanies

Sandwichbarsandcoffeestores

Hairdressingsalons

Dry-cleanersandlaunderettes

BarsandNightclubs

Assumptions:MonopolisticCompetition

1. Therearemanyproducersandmanyconsumers- theindustryconcentrationratioislow

2. Consumersareawarethattherearenon-pricedifferencesamongproductsi.e.thereisslightproductdifferentiation– non-pricecompetitionisstrongandplentyofconsumerswitchingtakesplace

3. Producershavesomecontroloverprice- theyare“pricemakers”not“pricetakers”butthepriceelasticityofdemandishigherthanitwouldbeundermonopoly(thecross-priceelasticityishigh)

4. Barrierstoentryandexitarelow– thisallowsproducersrespondtochangingprofitsignalsandmeansprofitsarecompetedawayinthelongrun

ShortRunPrice,OutputandProfit

MC

PriceandCost

Output

AC

MR

AR

Firmshavedownward-sloping demandcurvesbecausetheyhavesomedegreeofprice-settingpower

ShortRunPrice,OutputandProfit

MC

PriceandCost

Output

AC

MR

AR

P1

Q1WeassumethatfirmsareprofitmaximiserswhereMC=MR

ShortRunPrice,OutputandProfit

MC

PriceandCost

Output

AC

MR

AR

P1

Q1

C1

SupernormalProfit

AtpriceP1andQ1,supernormal profitsarebeingmadebecausePrice>AC

ExplainingAdjustmenttotheLongRun• Intheshortrun,profitscompetinginmonopolisticcompetitivemarketscanbeatanylevel• Unlikemonopoly,therearenobarrierstoentry• Sothepresenceofsupernormalprofitsactsasasignal• Thismeansthatshort-runsupernormalprofitattractsnewproducerswithnewproducts andsonormalprofitsonlyaremadeinthelongrunequilibriumi.e.whereAR=AC• Asmorefirmsenterthemarket,thedemandcurveforanyexistingfirmshiftstotheleftasconsumersopttobuyproductsofferedbyneworalternativecompanies.• ThedemandcurvecontinuestomovetotheleftuntilitistangentialtotheACcurve.• Atthispoint,themonopolisticallycompetitivefirmisatitsprofit-maximisinglevelofoutput(becauseMR=MC)butisalsomakingonlynormalprofit(becauseAR=AC)

(1)ShortRunPrice,OutputandProfit

MC

PriceandCost

Output

AC

MR1

AR1

P1

Q1

C1

(2)LongRunPrice,OutputandProfit

MC

PriceandCost

Output

AC

MR2

AR2

P2

Q2

Inthelong runequilibrium,theaveragerevenuecurveistangentialtoAC–meaningnormalprofitsarebeingmade

AStableLREquilibriumisUnlikely

• Inthelongrunequilibriuminmonopolisticcompetition,therepresentativefirminthemarketismakingnormalprofits.• Inreality,astableequilibriummaynotbereachedsincenewproductscomeandgo,andsomenaturallydobetterthanothers.Themarketmaybeinastateofconstantflux.• Existingproductswithinamarketwilltypicallygothroughaproductlifecyclethataffectsthevolumeandgrowthofsales• Thelengthoftheproductlifecyclevariesfrommarkettomarket.Manybusinessesspendheavilyonmarketing/innovationtoextendthelifeofprofitablebrands

MonopolisticCompetition&Efficiency

1. Pricesareabovemarginalcost– meaningthattheequilibriumisnotallocativelyefficient

2. Saturationofthemarketmayleadtobusinessesbeingunabletoexploitfullyeconomiesofscale- causingaveragecosttobehigher– thereforenotproductivelyefficient

3. Criticsofheavyspendingonmarketingandadvertisingarguethatmuchofthisspendingiswastefulandaninefficientuseofscarceresources.

4. Debateoverthesocialcostsofpackagingandnegativeexternalitiesislinkedtomonopolisticcompetition

5. Monopolisticcompetitionassociatedwithextensiveconsumerchoiceandinnovation– goodfordynamicefficiency

CaseStudy:UKTaxiIndustry

AddisonLeeFoundedbyminicabdriverJohnGriffinin1975withjustonecar,Addison Leehasbecomea

majorcompetitortoLondon'sblackcabsandnowcarriesmorethan10mpassengersayear.

BoughtbyCarlyle,theUShedgefundmanagerinJuly2013

PrivatehirevehiclesMinicabscannotbehailedfromthestreetandmustrelyon

telephoneandinternetbookingsandwalk-inreservations.Mostprivatehirevehicles arelicensedbuttherearealsosomeun-

licensedoperators

LondonBlackTaxisThereareover23,000blackcabdrivers.Entryisrestrictedtothosewithlicenceanddriverswhohave

passed“theKnowledge”

Afragmentedmarket;Thereareanestimated78,000taxisand153,000licensedprivatehirevehiclesinEnglandandWales.80%ofUKtaxisarerelativelysmallowner-operatorbusinesses.Theindustryasawholegeneratesrevenuesofnearly£9billionperyear

CaseStudy:UKTaxiIndustry

19.2 20.5 20.8 20.8 21.6 22.3 22.6 22.2

42.1 42.645.9 47.3

52 53.6 55.4 55.8

0

10

20

30

40

50

60

70

80

90

1999 2001 2004 2005 2007 2009 2011 2013

Taxisinthousands

London England/Wales

CreativeDestruction?TheRiseofUber

• ThetaximarketinLondonandmanyothercitieshasbeendisruptedbythearrivalofUber– asmartphonebasedcabservicethatallowsuserstohailacabusingtheirmobiledeviceandwhichissignificantlycheaperthantraditionalblackcabs.• Rememberthattechnologyactsasadisruptiveforceovercomingbarrierstoentry.InsomecitiesUberhasbeenbanned,notleastinplaceswhereestablishedtaxioperatorshavepoliticalinfluence.• Uberusesasurge-pricingmodel– thefareschargedarehigherwhendemandisrisingatpeaktimes.Thisisanexampleofpricediscriminationinordertomaximiserevenue.

Price&Non-PriceCompetitioninGymMarket

• TheUKgym/healthclubindustrygenerates>£2billionofrevenuesannuallywithover1,500businessesemployingnearly40,000people• Gymsandfitnesscentresareconcentratedinurbanareaswherehighpopulationdensitymakesbusinessesmorecommerciallyviable• Themarketpositionofmid-marketgymshascomeunderpressureinrecentyears.• Consumersareswitchingtowardsbudgetgyms,whichdonotrequirelong-termcontractsandchargelessbecausetheyonlyofferbasicservices

Price&Non-PriceCompetitioninGymMarket

PayasyougoBasicequipmentOftenoutoftown

Manyopen24hoursDryfacilitiesonly–

gym,classes

BudgetGyms

• Membershipsubscriptions

• Wet(spa,pool)anddryfacilities

• Carparking• Restaurants• Tailoredinstruction

Mid-RangeGyms

MonopolisticCompetition

IBEconomics:TheoryoftheFirm&MarketStructures