Figure 2. The same thing is true of roadside vegetable stands in the countryside. You will soon learn why this is. There are more similarities than differences between this module and the others that follow it.
What you learn in this module will carry over and help you understand the next ones, so the more effort you put into learning this one, the easier the next three modules will be. Privacy Policy. Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market. One of the defining traits of a monopolistically competitive market is that there is a significant amount of non- price competition.
This means that product differentiation is key for any monopolistically competitive firm. Although research in a niche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation.
Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences; differentiation is not the process of creating the differences between the products. In economics, successful product differentiation is inconsistent with the conditions of perfect competition, which require products of competing firms to be perfect substitutes.
Consumers do not need to know everything about the product for differentiation to work. So long as the consumers perceive that there is a difference in the products, they do not need to know how or why one product might be of higher quality than another.
For example, a generic brand of cereal might be exactly the same as a brand name in terms of quality. Differentiation occurs because buyers perceive a difference. Drivers of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it.
The major sources of product differentiation are as follows:. The objective of differentiation is to develop a position that potential customers see as unique. Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition.
A successful product differentiation strategy will move the product from competing on price to competing on non-price factors. The demand curve in a monopolistic competitive market slopes downward, which has several important implications for firms in this market. Explain how the shape of the demand curve affects the firms that exist in a market with monopolistic competition. The demand curve of a monopolistic competitive market slopes downward.
This means that as price decreases, the quantity demanded for that good increases. While this appears to be relatively straightforward, the shape of the demand curve has several important implications for firms in a monopolistic competitive market. Monopolistic Competition : As you can see from this chart, the demand curve marked in red slopes downward, signifying elastic demand.
This is due to the fact that firms have market power: they can raise prices without losing all of their customers. In this type of market, these firms have a limited ability to dictate the price of its products; a firm is a price setter not a price taker at least to some degree. The source of the market power is that there are comparatively fewer competitors than in a competitive market, so businesses focus on product differentiation, or differences unrelated to price.
By differentiating its products, firms in a monopolistically competitive market ensure that its products are imperfect substitutes for each other.
As a result, a business that works on its branding can increase its prices without risking its consumer base. Monopolistically competitive firms maximize their profit when they produce at a level where its marginal costs equals its marginal revenues. Due to how products are priced in this market, consumer surplus decreases below the pareto optimal levels you would find in a perfectly competitive market, at least in the short run.
As a result, the market will suffer deadweight loss. The suppliers in this market will also have excess production capacity. Monopolistic competitive markets can lead to significant profits in the short-run, but are inefficient. The most common example of this is the production of a good that requires a factory. If demand spikes, in the short run you will only be able to produce the amount of good that the capacity of the factory allows.
This is because it takes a significant amount of time to either build or acquire a new factory. If demand for the good plummets you can cut production in the factory, but will still have to pay the costs of maintaining the factory and the associated rent or debt associated with acquiring the factory. You could sell the factory, but again that would take a significant amount of time.
In the short run, a monopolistically competitive market is inefficient. It does not achieve allocative nor productive efficiency. Also, since a monopolistic competitive firm has powers over the market that are similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus, creating deadweight loss.
Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.
The profit the firm makes is the the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good..
Short Run Equilibrium Under Monopolistic Competition : As you can see from the chart, the firm will produce the quantity Qs where the marginal cost MC curve intersects with the marginal revenue MR curve. The price is set based on where the Qs falls on the average revenue AR curve. The profit the firm makes in the short term is represented by the grey rectangle, or the quantity produced multiplied by the difference between the price and the average cost of producing the good.
Since monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. Under monopolistic competition average revenue is more than marginal revenue because the firm has to lower the price to increase sales. Thus marginal revenue is less than average revenue i. Under monopolistic competition price is higher than price under perfect competition in long period because a perfect competition firm extends output up to the point where average cost is lowest i.
However, in monopolistic competition firm stops the production before it has attained the optimum output. It has been shown by Fig. In Fig. The equilibrium output is ON and equilibrium price is OP. In fig. The equilibrium output is ON 1 and price is OP.
In the equilibrium position the firm is earning normal profit. If we compare the equilibrium price under both market situations, it is clear that price in monopolistic competition market is higher than that of the price in perfect competition market. In the perfect competition market output is more than the monopolistic competition market output.
That is the reason that in monopolistic competition output is lower than the output in perfect competition as is clear from Fig. In the Fig 13 B. Perfect competition is an imaginary situation, whereas monopolistic competition is a reality.
Under perfect competition, an inefficient firm cannot exist but under monopolistic competition both efficient and inefficient firms can exist because buyers have their irrational preferences for goods in the market. Article Shared by. Related Articles. Ultimately, firms in both markets will only be able to break even by selling their goods and services. Both markets are composed of firms seeking to maximize their profits. In both of these markets, profit maximization occurs when a firm produces goods to such a level so that its marginal costs of production equals its marginal revenues.
One key difference between these two set of economic circumstances is efficiency. A perfectly competitive market is perfectly efficient. This means that the price is Pareto optimal , which means that any shift in the price would benefit one party at the expense of the other. The overall economic surplus , which is the sum of the producer and consumer surpluses, is maximized.
The suppliers cannot influence the price of the good or service in question; the market dictates the price. The price of the good or service in a perfectly competitive market is equal to the marginal costs of manufacturing that good or service. In a monopolistically competitive market the price is higher than the marginal cost of producing the good or service and the suppliers can influence the price, granting them market power.
This decreases the consumer surplus , and by extension the market's economic surplus, and creates deadweight loss.
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