Market structure of monopolistic competition is best described by Chamberlain’s model of contestable market that assumes that this situation is created when each of many sellers only deals with single differentiated product. Perfectly contestable market with many sellers is the major distinguisher of monopolistic competition from oligopoly.
While neo-classical theory assumes that all the firms operate in perfect information environment, Chamberlain provides good overview of the short-run behaviour of a firm in monopolistic competition, influenced by asymmetric information and bounded rationality. Under this assumption it is very common that firms sell relatively homogeneous product for different price, based on various pricing policies. Firms in monopolistic competition environment face with price discrimination that could be achieved through vertical integration, but at the same time undermined by opportunistic behaviour within firm’s supply chain. These relationships also affected by the complexity of the supplier – retailer – customer relations and reputation interdependency, namely principal-agent problem.
Let us look at the firm’s behaviour in a short-run. Under this situation, Dm is the market demand curve, while d is the individual firm’s demand curve. Individual firm’s demand curve is always more elastic than market response demand curve and, therefore, if an individual competitor reduces its price, it will not have significant impact on other firms’ sales. In fact it means that rivals will not react on the individual firm’s pricing policy. If firm X (for example) sets price at level P0, it earns economic rent and therefore, market becomes attractive for new entrants (Rickard, 2007). This situation can be sustained for a certain period of time, not affecting sales and revenues of existing firms and allowing for new entrants to the market.
In a Source: S. Rickard Monopolistic Competition
In a long-run, however, increased competition will affect the share of the market of firm X and, as a result, shift its individual demand curve d1 from point A to point B. From earning economic rent, all the sellers in monopolistic competition market now reach the point when their Short Run Average Costs equals Long Run Average costs and therefore, market situation is in its equilibrium, where no new entrants are attracted to the market due to high entrance costs. If all the firms on the market respond rationally on the price strategies it is expected that combined market response curve will follow the same trend, with lower elasticity to the change in price (shift Dm0 to Dm1). Point B is the Chamberlain’s equilibrium and the point of allocative efficiency (MR=MC) that at the same time represents the access capacity prediction of monopolistic competition. While we believe that this model is a good fit to explain market competition, it is still undermined by the assumption that all the firms face identical production costs (Rickard, 2007).
Allocative and productive efficiency for competitive firm, being a price-taker, plays significant role in its ability to sustain the business and meet market driven prices. It is the major distinguisher factor of monopolistic competition from the monopolistic firm that, in fact, sets the price. In monopolistic market, a firm can set the price above its marginal cost and therefore go above allocative efficiency level. In competitive market, long-term equilibrium is achieved at the allocative efficiency level. On the other hand, production possibility frontier in the economy (PPF) determines productive efficiency (MC = AC) and, taken into account competitive nature of monopolistic market, firms in this environment are more cost-driven and, consequently, more incentivised to achieve productive efficiency.
Given market conditions, we can evidence that in a long run monopoly will drive productive efficiency, mainly through economies of scale, with significantly lower focus on allocative efficiency. Firms in monopolistic competition, however, should be driven by both factors in order to meet market price level and achieve competitive cost structure.
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