ECON2/5: MONOPOLISTIC COMPETITION-S.5

This unit talks about monopolistic competition.It states its factors,advantages and disadvantages of monopolistic competition.

Monopoly
This is a market structure when the seller or produce is selling goods which serve the same purpose as other on the market though they appear different.

Factors of monopolistic competition

  1. There’re many firms in the industry i.e. many sellers and buyer.
  1. Each firm produces a product which is different from that of its competitors yet the products are substitutes.

The differences are created by trademarks, branding, colouring etc.

  1. There’s a lot of persuasive advertising and heavy advertising expenditure is a major characteristics of firms under monopolistic competition.

Each firm advertises a lot trying to convince buyers that its product is better than the rest. This is done on T.Vs, radios, newspapers etc.

  1. There’s freedom of entry and exist into and from the industry.

New firms are free to enter or join the industry and the existing firms are free to leave the industry in cases of losses.

  1. Elastic demand curve.

The demand curve of a firm under monopolistic competition slopes downwards from left to right and it’s elastic because of the availability of substitutes.

  1. The goal of the firm as in all market structures is profit maximization at a point where MC= MR.
  1. Because of product differentiation, firms under monopolistic competition are price makers.
  1. The producers in the long – run operate at excess capacity i.e. they produce  output than their capability.
  1. There’s grand loyalty which implies that the seller has customers who are loyal to him, those who believe that a particular brand is superior  will buy it whether prices increases or not.

Although pens may be basically the same, the market of bic pens claims to be only supplier of such pens and, the trademark bic, gives the maker monopoly powers over bic pens although it is true that he competes for the same market with producers of nice pens, fountain pens, pencils etc. the monopolistic appearance is with a particular product and the element of competition is in the market hence monopolistic competition. 

SHORT RUN EQUILIBRIUM OF A FIRM UNDER MONOPOLISTIC COMPETITION

Equilibrium will be attained at a point where MC = MR. short run equilibrium is similar to that of monopoly since the firm can make abnormal profits / losses.

monopolistic competition

LOSSES

monopolistic competition losses

monopolistic competition losses 2

Long – run equilibrium gives  a situation where the AR curve is tangent to the AC curve at the point of equilibrium where MC = MR.

A higher price OPe will be charged which is equal to the AC.

Firms will be producing at excess capacity although in equilibrium and the optimum output will not be their target. In the long – run, normal profits are realized where AC= AR (P).

NB:

The demand curve is tangent to the long run AC curve at point because the demand curve is not horizontal (like in perfect comp [tuition) but it slopes downwards to the right.

Examples of monopolistic competition may include producers of watches, pens, cars, tealeaves etc.

Advantages of monopolistic competition

  1. Product differentiation enables consumers get a variety of products.
  1. Because of competition amongst firms, there’s improvement in the quality of the products.
  1. Output is higher than under monopoly because there are many producers of differentiation products.
  1. Because of many firms, consumers enjoy low prices.

Disadvantages

  1. There’s under utilization of firms in the long run.

Since there’s excess capacity output produced is lower than that produces under perfect competition.

  1. In the long run, there’re no profits to make improvements so the firm may not expand to enjoy economies of scale.
  1. To maintain market share the firm has to advertise yet advertising is wastage of resources.
  1. Since there’s restriction of output i.e. production is at excess capacity, there’s a tendency of firms to charge a high price.
  1. In the long – run because there are no profits to invest in research firms will be stagnant.


OLIGOPOLY

Oligopoly is market structure where there’re a few large producers dealing in either homogeneous or differentiated commodities.

There is interdependence among producers since each firm knows that others may react to its charges in price, quantity and quality.

Where the commodities produced are similar, it is referred to as perfect oligopoly and where they are differentiated, it is referred to as imperfect oligopoly.

Because the firms are few actions of one firm have a significant effect on other.

Features of oligopoly

  1. Under oligopoly sellers are few each producing a considerable fraction of total output of the industry.
  1. Under oligopoly entry of new firms into the industry is blocked/ restricted.
  1. The market structure is characterized by a high degree of uncertainty in that any firm is not certain of the actions  of other firms in case of change in policies, quality/ quantity i.e. other firms may also change the price, increase the level of the advertising or introduce after sale services.
  1. There’s interdependence among firms under oligopoly i.e. the policies of one firm directly affect the other firms because the products are good substitutes e.g. if one firms reduces its prices the other firm may do the same.
  1. Oligopoly is characterized by a high rate of persuasive and informative advertising.
  1. Prices under monopoly tend to be rigid i.e. there’s price rigidity because if one firms increases its prices, it will lose customers to its rivals who may not have increased their prices and if one firms reduces its prices, the rival firms will reduce theirs too and its sales will not rise very much.
  1. Under oligopoly the demand curve is kinked where one part is elastic and the other part is inelastic.                 

oligopoly

The demand curve of an oligopolistic consists of 2 parts. The upper part is relatively elastic and the lower one is relatively inelastic.

The kink indicates price rigidity under conditions of oligopoly.

The firm cannot increase the price above the kink as it will lose sales and get less revenue because other firms won’t follow.

And it won’t reduce the price below the kink because it won’t benefit as other firms will also reduce their prices.    

Profit maximization of a firm under oligopoly

[Short run and long – run]

oligopoly 1

From the diagram above firms under oligopoly will be in equilibrium selling quantity OQe at price OPe which is the established price. The equilibrium output is produced at an average cost of C1 and sold at average revenue which is same as price.

Therefore firms under oligopoly enjoy excess / abnormal profits both in the short run and long – run mainly because of restricted entry of other firms. MC and AC curve lie within the portion XY on the MR curve and that is where MC=MR.

Point X is regarded as the upper limit and point Y as the lower limit therefore even when the cost of production is at X or Y, the same equilibrium price OPe will be charged implying that even if the cost of production is high / low it will not influence price of oligopolistic firms. This confirms price rigidity under oligopoly where prices do not change.

Competition under oligopoly is very high because there’re few firms which are large in size. They can compete by use of prices (price war).

A price war is a situation where a firm will try to maximize profits by controlling a bigger part of the market in way of setting a lower price than its competitors. By use of a price war, the first firm to reduce the price will undercoat the other and drive it out of business.

If the other firm does not go out of business, prices are likely to fluctuate over some time. However the 2 firms may later come to an agreement and decide on which price their commodities should be sold.

Formation of a cartel

Here; a formal agreement is made by a group of firms to decide upon the output, pricing and marketing of their products. Firms may form a market sharing cartel whereby they divide the market amongst themselves e.g. OPEC.

Allocating quota

Firms fix the maximization amount may put on the market.

Examples of imperfect oligopoly in Uganda include the soap industry, beer industry, petrol stations, and firms dealing in mobile phones.

Price leadership under oligopoly

This is a practice among oligopolistic firms in an industry where all firms follow the leader which is always the biggest firm in the industry. Firms agree among themselves to sell the product at the price set by the leader firm.

Price leadership can be in various types;-

  1. Dominant price leadership

Here, one big firm which is the largest in the industry dominates the market like a monopolistic. It sets the price that maximizes their profits and the other firms will set the same price for fear of being eliminated.

  1. Barometer price leadership.

In such a situation, there’s no leader firm but just one firm will appear to be the most intelligent and wise and it will announce a price that other firms will take up.

  1. Low cost firm.

The firms at the lowest cost will charge the lowest price and this price will be followed by even the high firms. However, although the high cost firm takes up the price it will not maximizes profits.

Advantages of oligopoly

  1. Competition leads to high quality products.
  2. There’s increase in consumers’ choice due to product differentiation.
  3. Non – price competition benefits consumers.
  4. There’s price stability due to price rigidity.

Disadvantages

  1. Price tends to be rigid which limits the level of profitability.
  2. Some firms restrict output under a cartel arrangement, temporary, shortages may be created which may lead to inflation.
  1. Due to restricted/ blocked entry, firms may become inefficient and produce poor quality products.
  1. Price – wars may occur which increase on the level of losses.
  1. Expansion of firms is limited since each firm has a considerable share of the market.

Word to note

  1. Collusive oligopoly.

This is a situation in which firms in a particular industry decide to join -as a single unit for the purpose of maximizing profits and negotiate on the share market. Collusion is another type of price leadership.

  1. Monophony

This is a market situation where there’s a single buyer of a commodity / service.

  1. Bi-lateral monopoly.

This is a situation in which a single producer (monopolist) of a product faces a single buyer (monopolist) of that product.

 

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ASSIGNMENT : MONOPOLISTIC COMPETITION-S.5 assignment MARKS : 10  DURATION : 1 week, 3 days

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