Monopolistic Competition – Efficiency and Welfare

Monopolistic Competition – Efficiency and Welfare


Welcome back to our discussion on monopolistic
competition. In the earlier 2 modules we have developed
the assumptions about monopolistic competition. We have understood what the products look
like in a monopolistic competition, how are they differentiated, how are they substitutable
and what does the demand curve look like and eventually we developed the profit maximizing
condition for monopolistic competition and we saw that saw the profit maximizing output
level that the firm chooses to produce and then it basically traces back the output along
the demand curve and decides what price to charge in the market. Then we went on to discuss that the average
total cost that the firm has that is going to determine if the firm is making any loss
or profit or zero economic profit and if the firm is making profit we saw that lured by
that profit other firms are going to enter the market and the firms which bear a loss
even in the long run they are going to exit the market. So this is this was the standard theory about
monopolistic competition basically discussing on about how profit maximizing output and
price is determined in a monopolistic competitive setup and so like all our previous discussions
on perfect competition monopoly etc. where we have looked at the welfare implications
of the market outcome so in this module also we are going to discuss about welfare or efficiency
implications of the monopolistic competition market outcome. So talking about long run outcome and efficiency,
in the long run entry and exit happens till average total cost is equal to price for all
firms and hence economic profit is equal to 0. But unlike perfect competition price is not
equal to minimum average total cost in the long run. Hence price is equal to average total cost
but it is more than the marginal cost that is the firm continues to charge a markup of
price over marginal cost in the long run. So in the long run although price is equal
to average total cost and the firm is basically having a economic profit equal to 0 but still
the price has a is a markup over the marginal cost of the firm at that level of output. So let me draw the figure again. So this is output, this is price. So in the long run this is the q and this is
the price. So in the long run the average so in the long run the cost is equal to price
for this firm. So economic profit is equal to 0. This is a typical firm that we are talking
about and economic profit is equal to 0 in the long run, yet the price is more than the
marginal cost, this is the marginal cost. So price is more than the marginal cost and
hence this is a difference that is there between perfect competition and monopolistic competition. In case of perfect competition, in case of
perfect competition in the equilibrium, price is equal to average total cost is equal to
marginal cost. So average total cost is equal to marginal
cost at the minimum average total cost. So this was the equilibrium, this was the
long run equilibrium in case of perfect competition but in case of monopolistic competition price
is equal to average total cost but is more than marginal cost. So this is the equilibrium in case of monopolistic
competition. So this is not minimum of average total cost
but average total cost is falling. Yet it is more than marginal cost. Hence there is a markup between price and
marginal cost in the long run for a monopolistic competitive outcome. Now monopolistic competition is less efficient
than perfect competition. So this is kind of evident from this from
the comparison of the 2 outcomes it is the difference in efficiency or difference in
welfare is quite apparent from these 2 because in case of perfect competition the price that
is charged is minimum of average total cost. So basically in the market the price that
is getting charged is the minimum price that is possible. It is the minimum average cost that the firms
are incurring and they are charging that price. But in case of monopolistic competition although
the firms are incurring zero economic profit yet the price that they are charging is not
the minimum cost at which they can produce. The average total cost is still higher than
the marginal cost and average total cost and marginal cost are the average total cost is
basically falling here. So basically that means that the firm is operating
at excess capacity. It is possible for the firm to increase output
and lower cost yet the firm is producing at a level where average cost is higher than
the marginal cost and average cost is falling. So the monopolistic competitor operates at
excess capacity. It operates at downward sloping path of the
cost curve and hence produces less than cost minimizing output. Production does not happen at minimum cost
as in perfect competition. Since price is more than marginal cost market
quantity is less than socially efficient quantity. However, government cannot intervene to reduce
prices or increase quantity because the firms are already operating at zero economic profit. So basically this means coming back to this
diagram it basically means that production does not happen here but production happens
here where the average cost is falling. So average cost is falling. In case of perfect competition, the production
happens here, in case of perfect competition but in case of monopolistic competition there
is excess capacity. So it is possible for the firms to increase
the output yet its cost is going to keep on decreasing yet the firm does not do that and
it produces at a level where the average cost is falling. Hence there is excess capacity at which the
firm is operating. Yet the firm is producing zero economic profit
since here it is tangent to, the price line is tangent to the average total cost hence
there is inefficiency in the market in the sense that the price that is getting charged
in the market is more than the marginal cost. That is the benefit from the product the benefit
that the or the willingness to pay for the product by the buyers is higher than the cost
at which the additional unit of output can be produced by the seller. So there is clearly an inefficiency existing
there because here in this situation it is possible for the firm to keep on increasing
output and the buyer will keep on demanding higher output at a lower price and it is possible
for the firm to keep on increasing output yet getting a yet incurring an average cost
which is yet it is in this region basically in this region it is see this is the perfectly
competitive output. So it is possible for the firm to keep on
or it is possible to imagine that the firm will continue to increase its output because
till the point where its average cost is minimum. So it is it is possible to imagine the price
also to fall to that level where average cost equals marginal cost equals the price charged
in the economy. In that case there would be perfect efficiency
would be reached but that is not happening here because the firm is charging a price
which is higher than the marginal cost. So however the problem is in case of monopoly
also the same thing was happening. In case of monopoly also the although in case
of monopoly there was not zero economic profit but in case of monopoly also this inefficiency
was there. There was this deadweight loss and in case
of monopoly also the firm was charging a price higher than the marginal cost because it has
some amount of market power but in that case the government could step in and say that
you have to increase your output. So it could it was possible for the government
to actually direct the monopoly to increase its output, lower its price etc. but in case
of monopolistic competition that is not possible because in the long run the monopolistic competitive
market where there is free entry and exit that ensures that the firm is producing at
a level where it earns zero economic profit. So in such a situation if the government intervenes
and tries to reduce the price even further in that case the firms are going to incur
negative economic profit or loss. In that case so the firm is going to exit
the market. So because of that it is not possible for
the government to intervene in such a case because the firms are already earning zero
economic profit. So although there is inefficiency in the market
yet the government cannot do anything here. So what are the welfare implications? Now there are broadly 2 welfare implications
of monopolistic competitive market output. The first is the product variety externality
of consumers. That is introduction of new products and new
entrants in the market raises surplus for consumers. What does this mean? This basically means as I said that whenever
the firm is incurring any positive economic profit other firms are going to enter the
market. Now these new firms are going to bring in
more differentiated products. Remember that every firm is striving to make
its product different in the eyes of the consumers from the existing products. So as that keeps on happening, the consumers
are benefited because they have more and more choice and the product could be differentiated
on the basis of quality also remember. So one can imagine that the product differentiation
actually makes the consumer better off. The consumer gets a whole variety of choice
to choose from and the consumer also gets better quality, better variety of products
and because of that the consumer surplus actually increases. The benefit, its willingness to pay for a
product that keeps on increasing because it is getting better and better product and so
its consumer surplus increases. Also because as more entrants are there, more
entrants are entering the market this demand curve gets split between lot of across different
other firms and because of which the individual firms get to charge lower and lower prices. So as they keep on charging lower and lower
prices the consumer is better off because on the one hand he is getting better choices,
more variety of products, better quality products but also lower prices for products as there
are lot of sellers in the market. But there is a flip side to it because welfare
is not only about consumers. A economy consists of both consumers and producers. So welfare is dependent on the welfare of
both consumers as well as producers. So although the consumers’ welfare is increasing
what happens to producer’s welfare? Now as the second point says the business
stealing externality faced by the producers is another welfare implication. When new firms enter the market, existing
firms may lose customers, face losses and sometimes may have to leave the market. So one can imagine that in a monopolistic
competitive market setup since it is easy to enter the market it is possible for new
firms to enter and bring in new varieties of products and it is possible for the firms
to actually steal ideas, steal products, product ideas from the existing firms and make them
even better and in the process they steal business from the existing firms who may have
to leave the market. So that is also possible. So such amount of competition in the market
because it is free entry and exit. It is possible to imagine that in such kind
of market setup there are continuously churning of new producers in the market, new sellers
are entering the market and as a result the old sellers are getting wiped out from the
market as new and new products are developed and circulated in the market so that is a
negative welfare implication on the producers in the market. The net result of the above are hard to measure
and hence there is not much that the policy makers can do. So on the one hand while consumers are better
off on the other hand one can imagine a whole lot of insecurity on the parts on the amongst
the producers because as new and new entrants enter the market and wipe off the existing
profits, wipe away businesses altogether, wipe away products altogether from the market. So however the it is a natural phenomenon
that keeps on happening and there is little that the government or any policy maker can
do in such kind of market. So coming back to another so we already saw
from the diagram that the firm is operating at excess capacity. It is operating at a level where average cost
curve is declining and it is tangent to the price line or the demand curve and hence the
firm is operating at zero economic profit. But one may wonder what is the logic behind
it. Why does the firm operate at excess capacity? Why does the firm operate at excess capacity
and not at the minimum point? What is the logic or intuition behind it? Now there could be 3 or 4 reasons behind it
one could imagine. First is the very obvious which very obvious
reason is these are all differentiated products. So these are all differentiated products so
there are whole lot of products which have a negatively sloping demand curve. So they have negatively sloping demand curve. So these are very highly differentiated products
and they have different negatively sloping demand curve and hence there is no way they
can be tangent to the minimum point of the average total cost curve for the firm. So each of these firms, so this is say firm
1, firm 2, firm 3. So each of these firms have a negatively sloping
demand curve and negatively sloping demand curve can be tangent only to the declining
portion of the average cost curve and hence this is the outcome where it is operating
at a level where there is excess capacity because there is there is a negatively sloping
demand curve. Had this been a homogenous product then all
the firms would be facing a flat demand curve. All the firms will be facing a horizontal
demand curve and in that case they would be operating at a minimum of the average cost. Now the second reason is that if you imagine
such a market where there are whole lot of product differentiation and all the firms
are existing coexisting in this market and each is trying to behave like a not a monopoly
but each firm has some control over its consumers and they are focusing on product differentiation
and catering to this demand curve. What they are not focusing on is that they
are not focusing on minimizing cost. They are not focusing on minimizing cost but
they are focusing on retaining these consumers and charging them a price which is minimum
in the long run that they can charge. So intuitively one could imagine that the
firms are coexisting in a live and let live kind of environment where they each of them
is focusing on product differentiation and not really focusing on price competition. They are not competing with each other in
terms of price but they are competing or they are trying to create their own niche clientele
by product differentiation and that is how we have developed this model and hence there
is excess capacity at which they have to operate because they each of them is facing a negatively
sloping demand curve and another intuition behind excess capacity is when we discussed
about the long run when we said that there is a profit to be made and there are firms
existing in the periphery who are sitting and watching the market and as soon as there
is profit to be made these firms enter the market. Now what happens in such a scenario? In such a scenario what happens is this demand
curve it gets split up into too many firms. So imagine this is a group of consumers who
used to buy from this single seller minty toothpaste and now they know that there are
whole lot of other flavours available in the market, different kinds of products, packaging,
etc. So now they get as new and new entrants are
there in the market this demand curve gets split up between 3, 4 more firms or even more
firms. So in that case the existing firms or the
new firms each of these firms are now going to cater to even lesser and lesser number
of consumers. So obviously they will be operating at excess
capacity because capacity has already been created. It is like having an if you imagine that there
is a residential new residential area coming up and initially there was only one, initially
there was only one store one grocery store and gradually more and more grocery stores
coming up in that area because they know that profit is to made. This one single store is making a profit. So more and more grocery stores enter the
market or enter that in that residential area more and more grocery stores come up. So now instead of the one grocery store now
10 more grocery stores are all going to cater to the existing number of residents who are
residing in that area. So basically each of them is now going to
operate at excess capacity. So it is not possible for each of them to
operate at marginal average cost instead they are all going to operate at excess capacity
and since each of them is product differentiating since the firms each of them is focusing on
product differentiation so that also is kind of reason for the firms to operate at excess
capacity and come up with more and more ideas for better product differentiation and maybe
have different this basically is reason enough for the firms to operate at excess capacity
so that they can keep on improving on the product differentiation that they are already
doing in the market and because of this for better differentiation of product they probably
would like to keep on operating at a excess capacity. So this these were the welfare implications
of a monopolistic competitive market and we have seen that although unlike monopoly the
monopolistic competitive firm does not have more than zero economic profit or positive
economic profit like perfectly competitive firms the monopolistic competitive firm has
zero economic profit in the long run because of entry and exit. But like a monopolist the monopolistic competitive
firm has its own unique product in the sense that they keep on product differentiation
to make keep their products different from the other products although all these products
are kind of substitutable. So in generally speaking these products are
substitutable but yet the firms strive to make their products different or create the
perception that the products are better than the other products in the market in the eyes
of the consumer. This they do through different either making
their products themselves slightly different or through marketing, through advertising,
through locational advantages, through packaging. So this is what the firms strive to they strive
to keep on doing and it makes sense for them to operate at excess capacity to keep on differentiating
their product from the rest of the market. So in the following module we are going to
see the role of advertisement in monopolistic competition and we are going to see that if
what are the opinions of people whether advertising is good or bad. This is what we are going to do in the following
module and complete our discussion on monopolistic competition. Thank you.

One thought on “Monopolistic Competition – Efficiency and Welfare

  1. mam I have no words to explain my feelings towards your teaching you are the ocean of knowledge thnk uu u n god bless you

Leave a Reply

Your email address will not be published. Required fields are marked *