Monopolistic Competition

[Qurratulain]

Model Assumptions


A monopolistically competitive market has features which represent a cross between a perfectly competitive market and a monopolistic market (hence the name). Below are listed some of the main assumptions of the model.
1) Many, many firms produce in a monopolistically competitive industry. This assumption is similar to that found in a model of perfect competition.

2) Each firm produces a product which is differentiated (i.e. different in character) from all other products produced by the other firms in the industry. Thus one firm might produce a red toothpaste with a spearmint taste, another might produce a white toothpaste with a wintergreen taste. This assumption is similar to a monopoly which produces a unique (or highly differentiated) product.

3) The differentiated products are imperfectly substitutable in consumption. This means that if the price of one good were to rise, some consumers would switch their purchases to another product within the industry. From the perspective of a firm in the industry, it would face a downward sloping demand curve for its product, but the position of the demand curve would depend upon the characteristics and prices of the other substitutable products produced by other firms. This assumption is intermediate between the perfectly competitive assumption in which goods are perfectly substitutable and the assumption in a monopoly market in which no substitution is possible.

Consumer demand for differentiated products is sometimes described using two distinct approaches: the love of variety approach and the ideal variety approach.

Love of Variety: The love of variety approach assumes that each consumer has a demand for multiple varieties of a product over time. A good example of this would be restaurant meals. Most consumers who eat out frequently will also switch between restaurants, one day eating at a Chinese restaurant, another day at a Mexican restaurant, etc. If all consumers share the same love of variety then the aggregate market will sustain demand for many varieties of goods simultaneously. If a utility function is specified that incorporates a love of variety, then the well-being of any consumer is greater the larger the number of varieties of goods available. Thus the consumers would prefer to have twenty varieties to choose between rather than ten.

Ideal Variety: The ideal variety approach assumes that each product consists of a collection of different characteristics. For example each automobile has a different color, interior and exterior design, engine features, etc. Each consumer is assumed to have different preferences over these characteristics. Since the final product consists of a composite of these characteristics, the consumer chooses a product closest to his or her ideal variety subject to the price of the good. In the aggregate, as long as consumers have different ideal varieties the market will sustain multiple firms selling similar products.

Depending on the type of consumer demand for the market, then, one can describe the monopolistic competition model as having consumers with heterogeneous demand (ideal variety) or homogeneous demand (love of variety).

4) There is free entry and exit of firms in response to profits in the industry. Thus if firms are making positive economic profits, it acts as a signal to others to open up similar firms producing similar products. If firms are losing money, making negative economic profits, then, one by one, firms will drop out of the industry. Entry or exit affects the aggregate supply of the product in the market and forces economic profit to zero for each firm in the industry in the long run. [Note: the long-run is defined as the period of time necessary to drive economic profit to zero.] This assumption is identical to the free entry and exit assumption in a perfectly competitive market.

5) There are economies of scale in production (internal to the firm). This is incorporated as a downward sloping average cost curve. If average costs fall when firm output increases it means that the per-unit cost falls with an increase in the scale of production. Since monopoly markets can arise when there are large fixed costs in production and since fixed costs result in declining average costs, the assumption of economies of scale is similar to a monopoly market.

These main assumptions of the monopolistically competitive market show that the market is intermediate between a purely competitive market and a purely monopolistic market. The analysis of trade proceeds using a standard depiction of equilibrium in a monopoly market. However, the results are reinterpreted in light of the assumptions described above. Also, it is worth mentioning that this model is a partial equilibrium model since there is only one industry described and there is no interaction across markets based on an aggregate resource constraint.



source: international economics

[Qurratulain]

THE EFFECTS OF TRADE IN A MONOPOLISTICALLY COMPETETIVE INDUSTRY


Assume that there are two countries, each with a monopolistically competitive industry producing a differentiated product. Suppose initially that the two countries are in autarky. For convenience we will assume that the firms in the industry are symmetric relative to the other firms in the industry. Symmetry implies that each firm has the same average and marginal cost functions and that the demand curves for every firm's product are identical, although we still imagine that each firm produces a product that is differentiated from all others. [Note: the assumptions about symmetry are made merely for tractability. It is much simpler to conceive of the model results when we assume that all firms are the same in their essential characteristics. However, it seems likely that these results would still obtain even if firms were not symmetric.]
In the adjoining diagram we depict a market equilibrium for a representative firm in the domestic industry. The firm faces a downward sloping demand curve (D1) for its product and maximizes profit by choosing that quantity of output such that marginal revenue (MR1) is equal to marginal cost (MC). This occurs at output level Q1 for the representative firm. The firm chooses the price for its product, P1, that will clear the market. Notice that the average cost curve (AC) is just tangent to the demand curve at output Q1. This means that the unit cost at Q1 is equal to the price per unit, i.e. P1 = AC(Q1) which implies that profit is zero. Thus the firm is in a long-run equilibrium since entry or exit has driven profits to zero.

Keep in mind that this is the equilibrium for just one of many similar firms producing in the industry. Also imagine that the foreign market (which is also closed to trade) has a collection of firms which are also in a long-run equilibrium initially.

Next suppose whatever barriers to trade that had previously existed are suddenly and immediately removed. That is, suppose the countries move from autarky to free trade. The changes that ultimately arise will be initiated by the behavior of consumers in the market. Recall that market demand can be described using a "love of variety" approach or an "ideal variety" approach.

In the love of variety approach the removal of trade barriers will increase the number of varieties consumers have to choose between. Since consumer welfare rises as the number of varieties increases, domestic consumers will shift some of their demand towards foreign varieties while foreign consumers will shift their demand towards domestic varieties.

In the ideal variety approach some domestic consumers will likely discover a more ideal variety produced by a foreign firm. Similarly some foreign consumers will find a more ideal variety produced by a domestic firm.

In either case domestic demand by domestic consumers will fall while domestic demand by foreign consumers will rise. Similarly foreign demand by foreign consumers will fall while foreign demand by domestic consumers will rise. Note that this is true even if all of the prices of all the goods in both countries are initially identical. In terms of the diagram, trade will cause the demand curve of a representative firm to shift out because of the increase in foreign demand, but, will cause the demand curve to shift back in because of the reduction in domestic demand. Since these two effects push the demand curve in opposite directions the final effect will depend upon the relative sizes of these effects.

Regardless of the size of these effects, the removal of trade barriers would cause intra-industry trade to arise. Each country would become an exporter and an importer of differentiated products which would be classified in the same industry. Thus the country would export and import automobiles, toothpaste, clothing etc. The main cause of this result is the assumption that consumers, in the aggregate at least, have a demand for variety.

However two effects can be used to isolate the final equilibrium after trade is opened. First, the increase in the number of varieties available to consumers implies that each firm's demand curve will become more elastic (or flatter). The reason is that consumers become more price sensitive. Since there are more varieties to choose between, a $1 increase in price of one variety will now lead more consumers to switch to an alternative brand (since there are more close substitutes available) and this will result in a larger decrease in demand for the original product. Second, free entry and exit of firms in response to profits will lead to a zero profit equilibrium for all remaining firms in the industry.

[Qurratulain]

***FIgure 1***

[Qurratulain]

The final equilibrium for the representative firm is shown in the adjoining diagram. [Keep in mind that these same effects are occurring for every other firm in the industry, both domestically and in the foreign country.] The demand curve shifts from D1 to D2 and the marginal revenue from MR1 to MR2 as a result of trade. The firm's cost curves remain the same. Entry or exit of firms causes the final demand curve to be tangent to the firms average cost curve, but, since the demand curve is more elastic (flatter) the tangency occurs down and to the right of the autarky intersection. In the end, firm output rises from Q1 to Q2 and the price charged in the market falls from P1 to P2. Although individual firm output rises for each firm, we cannot tell in this model setup whether industry output has risen. In the adjustment to the long-run zero-profit equilibrium entry, or more likely exit of firms would occur. If some firms exit then it remains uncertain whether fewer firms, each producing more output, would raise or lower industry output.

[Qurratulain]

***Figure 2***

[Qurratulain]

BENIFITS OF FREE TRADE UNDER MONOPOLISTIC COMPETITION

Welfare of individual consumers who purchase this product will be enhanced for three main reasons. First, trade increases the number of varieties of products for consumers to choose. Second, free trade reduces the price of every variety sold in the market. Third, free trade may increase the supply of products in other markets and result in lower prices for those products.
1) If the product is such that an individual consumer seeks to purchase a product closest to her ideal variety, then presumably with more varieties available, more consumers will be able to purchase more products closer to their ideal. For these consumers welfare will be improved. Other consumers however may not be affected by the increase in varieties. If, for example, the new varieties that become available are all more distant from one's ideal than the product purchased in autarky, then one would continue to purchase the same product in free trade. In this case the increase in variety does not benefit the consumer.

If the product is one in which consumers purchase many different varieties over time (love of variety) then because trade will increase the number of varieties available to each consumer, trade will improve every consumer's welfare. Of course, this is based on the assumption that every consumer prefers more varieties to less.

Thus regardless of whether the product is characterized with the ideal variety or the love of variety approach, free trade, by increasing the number of varieties, will increase aggregate consumer welfare.

2) The second effect of trade for consumers is that the price of all varieties of the product will fall. The prices fall because trade allows firm to produce further down along its average cost curve which means that it lowers it per unit cost of production. This implies that each product is being produced more efficiently. Competition in the industry, in turn, forces profit to zero for each firm which implies that the efficiency improvements are passed along to consumers in the form of lower prices.

3) Finally, the improvement in productive efficiency for each firm may lead to a reduction in the use of resources in the industry. This effect would occur if industry output falls or if output does not rise too much. Although the use of resources per unit produced falls, total output by each firm rises. Thus it is uncertain whether an individual firm would have to layoff workers and capital or whether they would need to hire more. Even if they hired more though, the possibility that some firms would drop out of business in the adjustment to the long-run equilibrium may mean that as an industry resource usage falls. If resource usage does fall and capital and labor are laid off, then in a general equilibrium system (which has not been explicitly modeled here) these resources would be moved into other industries. Production in those industries would rise leading to a reduction in the prices of those products. Thus free trade in the monopolistically competitive industry can lead to the reduction in prices of completely unrelated industries.

[Qurratulain]

THE COSTS OF FREE TRADE UNDER MONOPOLISTIC COMPETITION


There are two potential costs of free trade in this model. The first cost involves the potential costs of adjustment in the industry. The second cost involves the possibility that more varieties will increase transactions costs. Each cost requires modification of the basic assumptions of the model in a way that conforms more closely with the real world. However, since these assumption changes are not formally included in the model the results are subject to interpretation.
1) The movement to free trade requires adjustment in the industry in both countries. Although firm output rises, productive efficiency rises as well. Thus it is possible that each firm will need to lay off resources - labor and capital - in moving to free trade. Even if each firm did not reduce resources it is possible (indeed likely) that some firms will be pushed out of business in moving to the long-run free trade equilibrium. Now it is impossible to identify which country's firms would close, however, it is likely to be those firms who lose more domestic customers than they gain of foreign customers, or firms that are unable or unwilling to adjust the characteristics of their product to serve the international market rather than the domestic market alone. For firms that close, all of the capital and labor employed will likely suffer through an adjustment process. The costs would involve the opportunity cost of lost production, unemployment compensation costs, search costs associated with finding new jobs, emotional costs of being unemployed, costs of moving, etc. Eventually these resources are likely to be re-employed in other industries. The standard model assumption is that this transition occurs immediately and without costs. In reality, however, the adjustment process is likely to be harmful to some groups of individuals.

2) A second potential cost of free trade arises if one questions the assumption that more variety is always preferred by consumers. Consider for a moment a product in which consumers seek their ideal variety. A standard (implicit) assumption in this model is that consumers have perfect information about the prices and characteristics of the products they consider buying. In reality, however, consumers must spend time and money to learn about the products available in a market. For example, when a consumer considers the purchase of an automobile, part of the process involves a search for information. One might visit dealerships and test drive selected cars, one might purchase magazines that offer evaluations, one might talk to friends about their experiences with different autos. All of these activities involve expending resources - time and money - and thus represent, what we could call, a transactions cost to the consumer.

Before we argued, that because trade increase the number of varieties available to each consumer, each consumer is more likely to find a product which is closer to her ideal variety. In this way more varieties may increase aggregate welfare. However, the increase in the number of varieties also increases the cost of searching for one's ideal variety. More time will now be needed to make a careful evaluation. One could reduce these transactions costs by choosing to evaluate only a sample of the available products. However, in this case there might also arise a psychological cost because of the inherent uncertainty about whether the best possible choice was indeed made. Thus in welfare would be diminished among consumers to the extent that there are increased transactions costs because of the increase in the number of varieties to evaluate.

[Qurratulain]

THE NET WELFARE EFFECTS OF THE FREE TRADE UNDER MONOPOLISTIC COMPETITION


The welfare effects under the basic assumptions of the model are entirely positive. Improvements in productive efficiency arises as firms produce further down along their average cost curves in free trade. Consumption efficiency is raised because consumers are able to buy the products at lower prices and have a greater variety to choose from.
Potential costs arise in the model only if we introduce the additional assumptions of adjustment costs or transactions costs. The net welfare effect in the presence of adjustment and transactions costs might still be positive if the production and consumption efficiency effects are larger.