Monopolistic Competition - Product Pricing, Business Economics & Finance Video Lecture | Business Economics & Finance - B Com

today's lesson is all about monopolistic
competition today we're going to define
and discuss the market structure that is
monopolistic competition will identify
some examples of industries that are
monopolistically competitive and we'll
analyze the demand marginal revenue and
the costs of production as seen by a
monopolistically competitive firm to
determine the level of output and the
price that we will result in both the
short run and the long run in a
monopolistically competitive market so
in previous lessons we have discussed
two other market structures up to this
point we have learned about perfect
competition which is a market in which
there are thousands of identical sellers
selling a homogeneous product in which
firms are price takers faced horizontal
demand curves and earn zero economic
profits due to the very low barriers to
entry on the other extreme of the
spectrum of competition we've discussed
pure monopoly a market structure in
which there is a single seller selling a
unique product and enjoying the benefits
of high entry barriers meaning that the
firm can earn economic profits in the
long run
due to its price making power now
monopolistic competition is actually
closer to the perfectly competitive
market than it is to the monopolistic
market some of the characteristics that
exist in monopolistically competitive
markets include a large number of
sellers selling slightly differentiated
products now differentiated is a term
that means simply different unlike
perfect competitors monopolistic
competitors sell products that aren't
the same as every other firm an example
of this might be a restaurant that sells
Mexican food Mexican restaurants are not
the same as Italian restaurants for
example or Thai restaurants Mexican
restaurants differentiate their food by
producing a certain type of food
so the restaurant industry is actually a
good example of a monopolistically
competitive industry
now another characteristic of
monopolistic competition is that entry
barriers exist but are very low it is
quite easy to open a monopolistically
competitive business the costs of
getting into the industry are quite low
therefore firms will enter the industry
if economic profits exist now another
characteristic is that since the firms
are differentiating their output
slightly each firm has some price making
power now this implies that each
individual firm faces a downward sloping
demand curve this is in contrast to
perfect competition in which firms are
price takers and therefore each firm
faces a horizontal demand curve
determined by the price in the market
for its product next we can say that due
to the low barriers to entry that exists
economic profits are unsustainable in
the long run just like in perfect
competition if economic profits exist
firms will be attracted to the market
the demand as seen by the individual
firms in the market will fall and
therefore the price that they can
ultimately sell their output for will
fall due to the original economic
profits that may have been earned in the
short run so economic profits cannot be
earned in the long run because the entry
barriers are low and entry eliminates
profits finally we can say that due to
the price making power of monopolistic
competitors neither allocate 'iv nor
productive efficiency will be achieved
in the long run so let's get into our
graphical analysis of monopolistic
competition we can actually illustrate a
graph for an individual firm in
monopolistic competition based on some
of the characteristics that we've just
identified for example the fact that
firms differentiate their products imply
that they'll have some price making
power and that the demand that each
individual firm will face is downward
sloping so we can start by drawing a
downward sloping demand curve now this
is in contrast to
the perfectly elastic horizontal demand
curve seen by an individual firm in
perfect competition it looks more like a
monopolist demand curve its downward
sloping meaning that the firm can charge
high prices and sell small levels of
output or can charge low prices and
expect to sell very high levels of
output as we can see here there's an
inverse relationship between price and
quantity demanded for an individual
firms output in monopolistic competition
next we can examine marginal revenue for
a monopolistically competitive firm
since these firms are generally going to
be single priced sellers price
discrimination will be very difficult
under monopolistic competition due to
the fact that the firms don't have a
huge amount of monopoly power so a
single price seller in monopolistic
competition just like a single price
monopolist as we have shown in previous
lessons will have a marginal revenue
curve that lies below its demand curve
meaning that at any level of output the
firm's marginal revenue will be lower
than the price it's selling its output
for so let's draw a marginal revenue
curve that is connected to demand at a
level of output equal to 1 but slopes
down twice as steeply as demand due to
the fact that the seller must lower its
price in order to sell additional units
of output its marginal revenue will
always fall faster than the price of its
good so now we have the basic foundation
for a monopolistically competitive firm
diagram we've got the demand curve we've
got the marginal revenue curve all
that's missing of course is our cost
curves so let's go ahead and draw a
marginal cost curve now marginal costs
for a monopolistic competitor looks just
like it does for any other firm the
shape explained by the law of
diminishing marginal returns next we can
draw an average total cost curve and I'm
just going to go ahead and draw an ATC
curve anywhere on this graph making sure
that the relationship between ATC and MC
fits with everything we know about the
cost that a firm faces so once again HC
must intersect marginal cost at its
lowest point now what we have is a graph
for a monopolistic competitor in the
short-run we can show that following the
profit maximization rule of produce
where marginal cost equals marginal
revenue the monopolistic competitor will
want to produce at a quantity where MC
equals M R which is right here we'll
call that Q MC for the monopolistic
competitors quantity and it can charge a
price that corresponds with demand for
that quantity of output so just like we
showed in a monopoly diagram the price
the firm will charge is found by going
above the profit maximizing quantity up
to the demand curve and then over to the
price axis and to determine whether or
not this firm is earning economic
profits we can go up to the average
total cost curve and over to the price
and cost access and we can see that at
its current level of output in price our
firm is earning economic profits equal
to P minus ATC so we have a rectangle
here representing the firm's profits so
far this looks just like a monopoly
diagram and that's exactly what it
should look like these firms are price
makers they face a downward sloping
demand curve marginal revenue will
always be less than price and if they
are successfully differentiating their
products the firm should be able to earn
economic profits in the short run as we
have shown in this graph but now is
where things get a little bit different
than pure monopoly because another
characteristic of monopolistic
competition is that entry barriers are
low and that economic profits cannot be
earned in the long run so using our
diagram we have to show that in the long
run these profits will be eliminated so
we're going to do that now how would
this look in our graph and why would
these profits be eliminated well let's
give an example here let's go back to
our Mexican restaurant let's say that a
Mexican restaurant opens in the city of
Zurich for example where I live zurk
doesn't have a lot of Mexican
restaurants if a Mexican restaurant
opened here I can't help but think that
due to its highly differentiated product
the restaurant might actually earn
economic
profits but this is a market in which
the entry barriers are very low if one
Mexican restaurant came in and started
earning economic profits as we see here
it's one of hundreds of restaurants in
the city so it's not a pure monopolist
it's providing food just like all the
other restaurants but that particular
type of food is earning in large
economic profits so we would expect that
other restaurants would start making
Mexican food and as they did the demand
for this restaurants meals would start
to decrease so let's show what happens
when new firms enter the market for
Mexican food we can expect that this
demand and marginal revenue will no
longer be enjoyed there will be a lower
level of demand for our individual firm
here due to the fact that there is more
competition in the market for Mexican
food so I'm going to clean up this graph
a little bit get rid of our original
demand curve and show what happens when
demand decreases and we'll find our new
equilibrium level of output and price
following the lower level of demand that
occurs as new firms enter this market so
here we are we've got the firm's costs
and we can expect that when profits were
being earned new firms were attracted to
the market and what happens now there
are more substitutes in the Mexican food
market in Zurich Switzerland if there
are more substitutes then demand will
decrease for this individual restaurants
meals and it will become more elastic
the number of substitutes is the primary
determinant of price elasticity of
demand as there are become more
substitutes for Mexican meals demand
will decrease and it will flatten out
compared to the original level of demand
along with demand marginal revenue will
decrease as well marginal revenue demand
are equal at a level of output of 1
therefore the marginal revenue curve
shifts to the left and downwards and
becomes flatter we now have a new level
of demand we call this D 1 and marginal
revenue we'll call that M R 1 that is
lower than the original level of demand
how do I know this demand is lower than
the original level well because as we
can see there are no longer any economic
profits that are being earned it's now
impossible for a monopolistic competitor
to earn economic profits let me show you
why the firm will want to continue to
produce at the quantity where MC equals
mr this is the profit maximizing level
of output we can actually see that that
is now at a slightly lower quantity
because we left our dot behind from the
original mr curve so the quantity that
the individual restaurant will produce
has decreased we'll call this Q mc1 at
the new quantity due to the lower level
of demand the price that the restaurant
can sell its meals for has decreased as
well there's more competition and
consumers are now more responsive to
this restaurants prices because there
are more substitutes so the price that
the restaurant can sell for has also
decreased we can actually see that
before the original price was up here at
p1 now we have a price down here at p2
the decrease in demand for the
individual restaurants meals causes the
restaurant to produce a smaller quantity
and charge a lower price next we want to
determine whether or not a restaurant is
still earning economic profits and as
you can see it is not because at this
price it's just zoom in here but a big
red dot there we can see that the price
equals the average total cost so we can
look over here I'm actually the ATC
equals price in the long run due to the
entrance of new firms if price equals
average total cost then essentially
there are zero economic profits and that
fits with our characteristics of
monopolistic competition economic
profits cannot be earned in the long run
so how do we draw this graph to make
sure we always show that zero economic
profits will be earned in the long run
in monopolistic competition well look
closely at what we've done here we've
shown that in the long run
the entrance of firms will assure that
if profits are earned they will be
eliminated this restaurants demand
decreased until it is tangent to the ATC
curve so there actually has to be a
tangency here the demand curve is
tangent to the ATC curve meaning that at
the profit maximizing quantity the firm
actually breaks even there's no way for
this firm to earn economic profits if it
reduces its output let's say down here
to q0 you can see would be earning
economic losses because it's ATC would
be higher than the price right there the
ATC is greater than the price if the
firm increase its output to q2 the same
would be true the firm would be earning
economic losses because the ATC is
greater than the price the best a
monopolistic competitor can hope to do
in the long run is to produce at a level
of output where ATC equals price meaning
monopolistic competitors will only break
even in the long run now this is just
the fate of a monopolistically
competitive firm of course if entry
barriers are low any time economic
profits are being earned those profits
will likely be eliminated by the
entrance of new firms but the good news
is that if losses were being earned the
barriers to exit are also low so we
could show a situation in which a
monopolistic competitor is earning
economic losses if losses are being
earned individual firms would leave the
market increasing the demand for the
firm's that remain in the market until
once again demand is tangent to the
average total cost curve and the firm's
that have remained are breaking even
okay we're going to now clean up our
graph and we're going to look very
closely at it to determine whether or
not efficiency is going to be achieved
in monopolistic competition okay here I
have redrawn my monopolistic competitor
in its long-run equilibrium how do I
know that this firm and this market are
in a long-run
Librium well I can simply draw the
profit-maximizing quantity where MC
equals mr and see that at that quantity
demand is tangent to the ATC in other
words the price that the individual
firms can sell their output for is equal
to the firm's ATC there's no reason for
firms to enter or exit this market each
firm is breaking even there is no
additional economic profits that can be
earned therefore new firms will not
enter so the next question is are these
firms efficient we need to look at the
graph very carefully to prove that
neither allocated nor productive
efficiency will be achieved by
monopolistically competitive firms in
the long run so the reason for this is
that well if we look very close to here
we can see that at the quantity that
this firm is producing at that each firm
in this market is producing at the
minimum average total cost is not being
achieved so how do I know that that's
because marginal cost equals average
total cost at its lowest point so this
right here is where ATC is minimized in
other words that is the quantity that is
productively efficient I'll call that Q
PE for the productively efficient
quantity the firm is not achieving its
productively efficient quantity due to
its price making power the firm will
restrict its output charge a slightly
higher price than the minimum ATC and
therefore it will not be using its
resources in the least cost manner that
is our definition of productive
efficiency the next question then is
whether or not the firm in the
monopolistic lead competitive market
will be allocated li efficient and to
determine this we must look at demand
which is a single of marginal benefit if
marginal benefit equals marginal cost at
the firm's profit maximizing quantity
then we can say that the firm is
allocated Li efficient but let's look
closely here at this quantity the firm's
quantity we can see that the marginal
benefit to society is
greater than the marginal cost to the
firm so the firm is not being allocated
Li efficient it is restricting its
output it is producing something less
than the socially optimal quantity in
order to maximize its profits in this
case to break-even the socially optimal
quantity of course is where marginal
cost equals marginal benefit which is at
a slightly greater quantity so we can
put another quantity here and call that
Q s0 or allocated Li efficient quantity
so there you have it the monopolist
competitor will be neither allocated Li
nor productively efficient in the long
run simply due to the fact that it has a
downward sloping demand curve and a
marginal revenue curve that lies below
demand the firm will charge a price
higher than its minimum average total
cost and it will be selling at a price
that is greater than its own marginal
cost meaning that resources will be
under allocated towards monopolistically
competitive firms output even in the
long run even though the firm's will not
be earning economic profits in the long
run this should just reiterate the fact
that the only perfectly efficient market
structure is perfect competition only if
demand were horizontal could it be
tangent to the average total cost curve
at its minimum point
so only in perfect competition will
firms produce at the minimum ATC in the
long run and sell at a price that is
equal to their marginal cost in the long
run
so that wraps up our lesson on
monopolistic competition this will
probably be our only lesson on
monopolistic competition it's a very
simple market structure to understand it
shares some characteristics of perfect
competition including a large number of
sellers and low barriers to entry but it
also shares some characteristics with
monopoly such as downward sloping demand
seen by individual firms price making
power and product differentiation but
based on the low barriers to entry that
exists firms in monopolistic competition
will only break even in the long run so
there's another characteristic that they
share with perfect
predators drawing the graph is very
tricky we must be careful to show that
demand is tangent to the average total
cost curve your demand curve cannot
cross your ATC curve when showing a
monopolistic competitor in its long-run
equilibrium if it did cross the ATC
curve then there would be the
possibility of earning economic profits
in the long run but we know that due to
the low barriers to entry that this is
not a possibility