Monopolistic Competition

Introduction

There are four market structures; perfect competition, pure monopoly, monopolistic competition and oligopoly. These four each have their own distinct, and in some cases, similar characteristics. In this paper, I will highlight these characteristics and depict and explain each of the pricing strategies, demand and cost curves. However, the true reason for doing so is to distinguish each market structure from the other to truly understand how a firm makes it pricing and supply decisions, and how these decisions affect the firm in both the short and long run.

For the paper, I decided to look at Imperial Cafeteria and Take Away as a possible base for discussions. It is a monopolistically competitive firm because: 1.) they share the market with many other firms, 2.) they advertise highly on radio as well as on television, 3.) their products are similar to others in the market, but is differentiated when considering service, quality and location, and 4.) there is easy entry and exit in this market. Sure, these are all characteristics of monopolistic competition, but how does Imperial's determine it profit maximizing point, or point of productive efficiency? These questions will all be answered shortly.

Perfect Competition

A perfectly competitive market is described as one where no single producer or consumer has the power to influence price or quantity. Firms in these markets are a price taker, which means that the market sets the price that they must abide by. In this market structure, large numbers of buyers and sellers, each who are so small that they produce an exceedingly small fraction of total output, therefore, each firm's actions have no significant impact on others. These firms also produce goods and services that are homogenous, or in other words, perfect substitutes. Therefore, there is no product differentiation. There is also perfect information, because all firms and consumers know the prices set by all firms. Free entry is also an important characteristic of a perfectly competitive market as any firm may enter or exit the market as it wishes. Unique to perfectly competitive markets are two important attributes, allocative and productive efficiency. Allocative efficiency occurs when price is equal to marginal cost, and this point, the good or service is available to the consumer at the lowest possible price. Productive efficiency occurs when the firm produces at the lowest point on the average cost curve, therefore the firm cannot produce the goods at a cheaper rate. This can only be seen in perfect competition, because if a firm was not producing at that point; another firm would be able sell products at a lower price.

Short-Run and Long-Run Profits and Losses

In the short-run, individual firms can make profits. This situation is shown in (Fig. 1), as the price or average revenue (P), is above the average total cost (ATC).

Unlike the markets of a monopoly or oligopoly, it is impossible for a perfect competitive firm to earn profits in the long run. If a firm earns profit in the short-run, this occurrence will encourage other firms to enter the market. The increased competition will drive the market price down, lowering the average revenue and marginal revenue curves until all firms are earning normal profit. Therefore, the horizontal demand curve (P=MR=AR) will meet the average total cost curve (ATC) at its lowest point (Fig. 2).

Then again, if firms are making a loss, some firms will leave the industry, reducing the supply and increasing the price (Fig. 3). Therefore, all firms can only make normal profit in the long run.

Decision to Shutdown

In a perfectly competitive market, the firm accepts the current market price (P), and it has no control over the price. Therefore in order to continue producing, (P) has to be higher than average variable cost (AVC). In other words, the line representing market price should always be above the minimum point of the (AVC) curve. If (P) is equal to (AVC), the firm should continue operating because it is at least covering its average variable cost; which is better than not producing and earning nothing at all. However, if (P) is less than (AVC), the firm should shut down completely (Fig. 4), because it cannot cover its variable costs as well as other fixed costs that maybe associated with producing the product.

Monopoly

A monopoly is characterized as a market wherein there is only one provider of a good or service. A few characteristics distinguish a monopoly from other market structures. Firstly, in a monopoly the good or service that the firm provides has no close substitutes. Another characteristic of a monopoly is that it is a price maker, meaning that the firm controls the total supply of the industry, thereby, being able to exercise a significant degree of control over the price by changing the quantity supplied in the market. Yet, in my opinion, the most important characteristic is barriers to entry. With these barriers to entry, monopolies make it impossible for firms to enter the market. In the case of legal barriers, governments can franchise only one firm to operate an industry, provide licensing designed to ensure a certain level of quality, or award patents to encourage invention and creativity. Barriers are also present when concerning economies of scale. Public utilities such as water and electricity are normally given exclusive monopoly rights because governments refer to them as natural monopolies. This means that one large firm, specializing in electricity, can provide the entire output of the market at a lower price than two or more smaller electrical firms. The cost advantage of having a natural monopoly is economies of scale. The last barrier to entry occurs when a firm has control over an important input.

It is aware that a monopoly will sell a lower quantity of goods or services at a higher rate that those in a perfectly competitive market because of the enormous profit that they gain. Yet, there is a social welfare loss because the monopoly is not producing enough of the good, so consumers must choose inferior products. These monopolies also become complacent over time, because they don't have to be innovative to compete in the market.

What makes Perfect Competition different from a Monopoly?

A firm in a perfect competitive market is a price taker that faces a horizontal demand curve. A price taker cannot choose the price that they sell at, because, if they set it above the equilibrium price, they will sell none. If they set it below the equilibrium price, they will have an infinite number of buyers, and actually