Perfect Competition vs. Monopolistic Competition in Markets

Perfect Competition and Monopolistic Competition

A perfectly competitive market does not have barriers to entry or exit and is characterized by many producers and many consumers, all of whom are price takers—a term that means the suppliers and buyers cannot affect the price as they do not have market power. Monopolistically competitive markets do have some barriers to entry and exit. Consumers can find substitutes for all of the goods in a competitive market, whereas high product differentiation is seen in a monopolistically competitive market. Indeed, one of the reasons that a firm can achieve a monopoly for a product is that the business has been successful in its efforts to differentiate a product, as perceived by its customers.

The ability of a business to make profits in the long run is related to the elasticity of demand. Perfectly competitive and monopolistically competitive markets both demonstrate elasticity of demand in the long run. That is to say that consumers in both markets are sensitive to price, so that the demand for products decreases if the prices rise.

Cost, Profit, and Production

A small difference in elasticity between the two types of competition does exist. In a perfectly competitive market, the demand curves are perfectly elastic: an incremental price increase causes the demand for a product to cease. In contrast, demand curves are not perfectly elastic in monopolistic competition. Businesses have market power in monopolistic competition, which means that these firms can raise their prices and not see all of their customers vanish. A perfectly competitive market is perfectly efficient. What this means is that the profit of any firm in a competitive market cannot increase without reducing the profit of another. This is because consumers can select substitute products without losing any advantage or without having to pay more for the substitute good. Suppliers cannot determine the price of a product or service because the market dictates the price in a competitive market.

When prices fall, consumers will generally buy more of a good or service; this is reflected in a downward sloping demand curve. Alternately, an upward sloping supply curve represents the willingness of producers to sell fewer goods or services when prices fall. Market equilibrium is represented by the intersection of these two curves—and it is considered to be the optimal outcome for all actors in the market. In a monopolistic market, output is lower than it is in a competitive market, and the prices in the monopolistic market are also higher. This creates what is known as deadweight loss or a welfare loss for society. This is a primary reason why monopolies generally do not create the best situations for societies.

Businesses try to maximize revenue while simultaneously minimizing costs. This requires a business to keep an eye on changes in both revenue and costs, which is referred to as "looking at the margin." That is to say that businesses scrutinize marginal revenue—changes in revenue—and marginal costs—changes in costs—for every unit produced. The relationship that is pivotal to profit maximization is this: if the increase in revenue is larger than the increase in costs, then producing more of the goods or services will still raise profit. This relationship will continue until the marginal revenue (MR) equals the marginal cost (MC). Another way of showing profit maximization is: MR = MC. All other things remaining the same, it will be easier to create profit in the short term rather than over the long term. Indeed, economic theory suggests that firms cannot be profitable over the long term.

However, what is referred to as profitability is not the same as accounting profitability. Accounting profit is just the difference between total costs and total revenue—or explicit costs that generate an increase in debt or an outflow of money. On the other hand, economic profit is total revenue minus total costs, which means that it includes implicit costs. In addition to opportunity costs, economic profit also must account for the effort, money, and time that an owner invests in a business. In the long run, owners will need to be compensated for their opportunity costs. Over the long run, in order to have an economic profit, a business will need to demonstrate positive accounting profit with regard to the amount of opportunity cost the business has accrued. Normal profit must be at least the minimum needed for production—including capital, labor, materials, and other resources.

Transaction Costs, Imperfect Information, and Behavioral Economics

Transaction costs are expenses incurred when securities instruments are bought or sold. The factors that contribute to transaction costs include the commissions charged by brokers and the spreads—which are the differences between the price the buyer pays for a security and the price that the dealer paid for the security. Even real estate, which is considered an investment or an asset, entails transaction costs for closing costs and the real estate agent's commission. Investors pay considerable attention to transaction costs since they are a primary element of net returns on investments. Over time, transaction costs diminish returns because the amount of capital that can be invested is reduced and the transaction costs themselves can reach thousands of dollars. For these reasons, it behooves an investor to try to keep transaction costs down.

In an imperfect market, information is not shared quickly with all constituents and buyers and sellers are not immediately matched. The concept of a perfect market is not a reality but is instead a model that provides a standard for the status of the current market. Imperfect markets are everywhere, even in the United States, which is considered the most sophisticated financial market in the world. Market inefficiencies prevail, information is improperly disseminated, and price corruption is commonplace.

Pricing Strategy in Action

Behavioral economics theory argues that even when people have perfect information, they do not always make rational decisions. Traditional economic theory is based on the idea that people who are actors in the markets make rational decisions based on complete information, and that everyone has the same information at fundamentally the same time. The field of behavioral economics combines the disciplines of psychology and economics, emphasizing research about whether the economic constructs of utility and profit maximization actually reflect the behavior of individuals and institutions.

The typical pricing strategy used by movie theaters shows different admission charges for people of different ages and with particular status, such as senior citizens or high school and college students. In addition, lower admission charges are associated with matinee or afternoon showings of films. This pricing strategy is not based on whimsy or altruism, but instead reflects the primary target audience of movie theaters. Most of the people who attend movie theaters today are young males—Generation X or Millennials—since this is the group with the freedom and discretionary dollars to make movie-going an easy and frequent decision. Sporadic and limited releases of "chick flicks" or romantic movies also attract audiences in this young age group, generally, along with women of all ages. Hollywood produces films for this most lucrative audience.

Consider that many elderly film buffs do not like to drive at night, so they tend to view films in the afternoons. Also note that elderly people may have compromised hearing or more stringent behavioral standards than people in other demographics; this may cause them to avoid the date night younger crowd who may be raucous and noisy. Elderly people may find that, even though children take a while to settle down at the theater, they are mostly accompanied by adults who will press for quiet, attentive behavior from their youngsters, in part to feel like they are getting their money's worth and in order to not be embarrassed by unruly children. Additionally, fewer elderly people go to movie theaters compared to the teen and young adult market. Given these factors, reduced admission fees for senior citizens makes sense—and does not overly impact the profitability of the theater business.

Fewer films are made for audiences of children and families to attend together; when family films are released, they very often take place during school holidays, which encourages attendance. Ticket sales for new releases of films for kids and families generally reach high levels immediately, and if the film achieves a good early reputation, box office sales climb. The sheer number of people buying tickets for a movie for kids and families makes up for any gain that might be achieved by charging an adult fee, especially given the short window for trying to maximize profit. In economic terms, consumer demand is likely to drop if prices are uniform for all age-based and status-related groups. Moreover, film buffs today can easily substitute a theater-based film experience with streaming videos at home, or buying or renting DVD movies very shortly after their release.