Monopolistic Competition

August 28, 2017 Economics

Contents Question 1. 1 – Monopolistic Competitors3 Question 1. 2 Non-price competitors5 Question 1. 3 – Substitutes & Compliments6 Perfect substitutes as in the Chocolate Industry:7 Perfect complement8 Question 2. 1 – Structuralist model of the inflation process9 Question 2. 2 – Inflation targeting approach9 References9 Question 1. 1 – Monopolistic Competitors Monopolistic competition is a market situation in which there is a large number of sellers and large number of buyers whereas monopoly means a market situation in which there is only a single seller or supplier of goods and services in the entire market and large number of buyers.

South Africa’s chocolate market is a monopolistic market situation since it has got more than one supplier, the major ones being Cadbury and Nestle, and a rapidly growing large market – buyers, being “more than R3-billion, and growing at an estimated 3% per annum” according to Angela Zachariasen and Lorna Schofield, 31 July 2008. In monopolistic competition, there are close substitutes in the sense that products are different in terms of size, colour, packaging, brand, price, shape and so on as in case of chocolates, soap, toothpaste et cetra but in monopoly, there is no close substitute of the good.

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Thus in monopolistic competition, products and services are not homogeneous but they are slightly differentiated from those of competitors. For example, Cadbury’s chocolate slabs, Dairy Milk, Top Deck, Wholenut, Mint Crisp Fruit & Nut or Lunch Bar can be easily substituted for Nestle`s brands that include Bar-One, KitKat, Smarties, Tex, Crisp, Rolo, Quality Street and Passions. Another feature of monopolistic competition is that firms engage in other forms of competition such as aggressive advertising but in monopoly, there is hardly ever any advertising.

This is mainly due to the fact that where there are many sellers each and every player would like to get a fair share of the market since it is impossible to get the whole market share, thus the need to advertise and do promotions. This closely identifies with the chocolate companies in South Africa, Cadbury and Nestle, that normally carry out vigorous advertising campaigns, in-store and outdoor promotions.

On the other hand, where there is only one market player, monopoly, there is no need for aggressive advertising campaigns rather the advertising in this situation serves to inform the public about certain organizational or operational changes and developments rather than to out compete rivalries. Another distinct feature of a monopolistic competition is that firms are free to enter or exit the industry.

As the market becomes lucrative, any firm can enter the market as there are no barriers to entry and when competition intensifies and becomes unbearable the same firm is free to exit the industry. The history of Cadbury and Nestle in South Africa goes back to the early 1900s, when both first established their factories in the Eastern Cape. On the other hand, a monopoly operates with no threat from other entries and can not freely exit the industry due to regulatory rules, nature of business and so on.

In monopolistic competition, demand curve faced by the firm is more elastic because of availability of close substitutes. It means if a firm raises its price, it will lose its large market share as customers in large will shift to close substitutes available in the market whilst in monopoly, the demand curve faced by the firm is less elastic because there are no close substitutes. The later implies that if the firm raises its price, quantity demanded will not drastically fall quantity as there is only one player in the market.

Unlike the monopolistic market in South African chocolate industry with 2 dominant players, Cadbury and Nestle, in a monopoly market situation entry is restricted and there are no close substitutes for that particular product and the later exists in some cases like where; 1. there are patent rights conferred upon a single firm for a product, 2. there is a limited strategic resource, 3. economies of scale are required in order to be profitable or 4. extensive financial resources or expertise is required to enter a market. MANCOSA, Economics Study Guide, 2010) The impact of monopolistic competition upon the chocolate industry in South Africa is that; there may be flooding of companies into the market and the firms’ individual share of the market may be drastically reduced resulting in lower profits or economic profits instead of the supernormal profits that firms so much desire in order to expand or grow. On the other hand, monopolistic competition compels firms to invest in research and development in order to increase production and operational efficiency a factor which support economic growth in the country.

The quality of service within the industry will be generally increased not mentioning the lower prices that firms will have to charge on the chocolates in order to remain in business. The lower prices will then imply that a firm has to come up with other non-price competing strategies such as product differentiation, advertising, promotions and so on. Question 1. 2 Non-price competitors Non-price competition is a marketing strategy “in which one firm tries to distinguish its product or service from competing products on the basis of attributes like design and workmanship” (McConnell-Brue, 2002, p. 3. 7-43. 8). The firm can also distinguish its product offering through quality of service, extensive distribution, customer focus, or any other sustainable competitive advantage other than price. It can be contrasted with price competition, which is where a company tries to distinguish its product or service from competing products on the basis of low price. Non-price competition typically involves promotional expenditures, such as advertising, selling staff, sales promotions, coupons, special orders, or free gifts, marketing research, new product development, and brand management costs.

Firms will engage in non-price competition, in spite of the additional costs involved, because it is usually more profitable than selling for a lower price, and avoids the risk of a price war. Although any firm can use non-price competition, it is most common among monopolistically competitive firms. The reason for this is that firms which operate in the monopolistically competitive market are price takers, that is, they simply do not have enough market power to influence or change the price of their good.

Consequently, in order to distinguish themselves, they must use non-price means. Monopolistic competitors are also known as non-price competitors as can be illustrated by wide product range competition by Nestle and Cadbury. Both companies have a got a very wide product range and are vigorously growing the product range with Nestle investing heavily in the East London plant increasing its chocolate-producing lines from six to eleven in 2007 while Cadbury chocolate manufacturer continue to invest significantly in its Port Elizabeth, Nelson Mandela Bay manufacturing plant.

In a monopolistic market situation, competition ceases to be based upon prices since there are many buyers and sellers of the same product. A slight increase in the price results in reduced quantity demanded whereas a cutting on the price results in a firm making losses. To this end, the only logical way to compete in such an industry will be to concentrate on other strategies such as baring, advertising, quality service, differentiation and promotions.

Differentiation: Here the business concentrates on achieving superior performance in an important customer benefit area, such as being the leader in service, quality, style, or technology—but not leading in all of these things. For instance Cadbury differentiates itself through leadership in manufacturing plant by having a world-class chocolate manufacturing plant, situated in Port Elizabeth, Nelson Mandela Bay. . Question 1. 3 – Substitutes & Compliments A substitute good, in contrast to a complementary good, is a good with a positive demand.

This means a good’s demand is increased when the price of another good is increased. Conversely, the demand for a good is decreased when the price of another good is decreased. If goods A and B are substitutes, an increase in the price of A will result in a leftward movement along the demand curve of A and cause the demand curve for B to shift out. A decrease in the price of A will result in a rightward movement along the demand curve of A and cause the demand curve for B to shift in. Classic examples of substitute goods include margarine and butter, or petroleum and natural gas.

The fact that one good is substitutable for another has immediate economic consequences: insofar as one good can be substituted for another, the demand for the two kinds of goods will be bound together by the fact that customers can trade off one good for the other if it becomes advantageous to do so for example in the case of the chocolate industry where one can easily trade off one brand chocolate for another. An increase in price (ceteris paribus) will result in an increase in demand for its substitute goods. For example if Cadbury increase prices for its chocolate slabs, then demand for Nestle chocolates will increase as ustomers respond to the price increase. The extend of the demand for substitutes then depends on the price sensitivity of the market. If the buyers are very sensitive then demand for substitutes increases sharply but if customers are not so much price sensitive then there will be only a slight increase in demand for substitute chocolates from Nestle or other brands. It is important to note that when speaking about substitute goods we are referring to about two different kinds of goods; so the “substitutability” of one good for another is always a matter of degree.

One good is a perfect substitute for another only if it can be used in exactly the same way for in the Chocolate Industry. In that case the utility of a combination is an increasing function of the sum of the two amounts, and theoretically, in the case of a price difference, there would be no demand for the more expensive good. Below is a diagram illustrating Perfect substitutes as in the Chocolate Industry: Indifference curve for perfect substitutes Perfect substitutes may alternatively be characterized as goods having a constant marginal rate of substitution.

Alternative brands of chocolates may be used as an example of perfect substitutes. As the price of Cadbury chocolates rises, consumers would be expected to substitute these for example, Lunch Bar, in equal quantities by another brand such as Nestle’s Bar One or Kit Kat, thus total chocolate consumption would remain constant. Thus if one manufacturer raises the price of its chocolates, consumers would be expected to switch to a lower cost manufacturer. A complementary good, in contrast to a substitute good, is a good with a negative cross elasticity of demand.

This means a good’s demand is increased when the price of another good is decreased. Conversely, the demand for a good is decreased when the price of another good is increased. If goods A and B are complements, an increase in the price of A will result in a leftward movement along the demand curve of A and cause the demand curve for B to shift in; less of each good will be demanded. A decrease in price of A will result in a rightward movement along the demand curve of A and cause the demand curve B to shift outward; more of each good will thus be demanded.

Examples of complementary goods include: Peanut butter and jelly, Printers and ink cartridges, DVD players and DVDs, Computer hardware and computer software. Below is the diagram of complementary goods: Perfect complement Indifference curve for perfect complements A perfect complement is a good that has to be consumed with another good. The indifference curve of a perfect complement will exhibit a right angle, as illustrated by the figure at the right. Few goods in the real world will behave as perfect complements.

One example is a left shoe and a right; shoes are naturally sold in pairs, and the ratio between sales of left and right shoes will never shift noticeably from 1:1 – even if, for example, someone is missing a leg and buys just one shoe. In marketing, complementary goods give additional market power to the company. It allows vendor lock-in as it increases the switching cost. However, complementary goods have got minimal or no effect at all on chocolate companies such as Cadbury and Nestle. Question 2. 1 – Structuralist model of the inflation process Structural models carry positive connotations in economics.

The usefulness of any model is related to the purpose of analysis. One of the main concerns of Central Banks around the world is to understand the dynamics of the inflation process and to forecast as accurately as possible the future path of this variable. With respect to the former objective, New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models have recently been the more popular choice. These provide a more structuralist approach to the inflation process. A structural model is synonymous with a model which is made up of equations that are derived from (or at least consistent with) modern macroeconomic economic theory, i. . , each equation has a structural interpretation. Accusations from COSATU and SACP of narrowed scope of policy changes effects indicate that there was a perception that there was no structural interpretation to inflation targeting. It would appear that when it comes to forecasting, on the whole DSGE models appear to do better in explaining the longer-term evolution of variables while atheoretical time-series approaches have been shown to forecast better in the short-term. The reasons for using the structural frame of the New

Keynesian Phillips Curves (NKPC) within models are twofold: (i) to afford a role for inflation expectations in forecasting models (ii) There is some evidence that the present-value form of the NKPC equation, in conjunction with forecasts for future marginal costs, is somewhat successful at forecasting inflation. Question 2. 2 – Inflation targeting approach Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or “target”, inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.

Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. Examples: •if inflation appears to be above the target, the bank is likely to raise interest rates. This usually (but not always) has the effect over time of cooling the economy and bringing down inflation. •if inflation appears to be below the target, the bank is likely to lower interest rates. This usually (again, not always) has the effect over time of accelerating the economy and raising inflation.

Under the policy, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability. As an example, since 2006 South Africa increased interest rates by five percentage points to track a rise in inflation (based on CPIX) even though the rise in CPIX was due to the supply shocks of worldwide fuel and food price increases. Following the global financial crisis of 2007–2010 the prime lending rate was decreased to 2006 levels, but it still remained high at 7. %. The reduction also came too late for the housing market and motor manufacturer and retail industry all of which suffered heavy losses due to the pressure on consumer borrowing. This in turn led to job losses in these sectors. According to a speech made by the then Governor of the Reserve Bank of South Africa, Mr T T Mboweni on the 2nd of September 2003 at a Management dinner advantages of inflation targeting outweigh the disadvantages. Although Mr Mboweni did mention that inflation targeting, if pursued at any costs, ran the risk of inefficient output stabilisation.

Significant supply shocks to the economy such as sharp oil price movements, can require very large monetary-policy adjustments to bring inflation back inside the target range within the stated time horizon. For such exceptional events, some discretion and patience in re-achieving the target range should therefore be allowed for. Herein is a quote of his speech “The advantages of inflation targeting are also worth highlighting. Firstly, transparency – the concept is easily understandable, with the ultimate policy objective translated into an explicit target value.

Secondly, inflation targeting provides enhanced clarity about the objective of monetary policy, which is conducive to sound planning in both private and public sectors. Thirdly, the framework provides for improved accountability of the Reserve Bank. It eliminates the need to rely on a stable relationship between the money stock and inflation, which has become increasingly difficult to identify; inflation targeting enhances economic policy co-ordination with government and the central bank both publicly committed to the same inflation target.

And lastly inflation targeting provides an anchor for inflation expectations and price and wage setting, thus reducing the friction which arises from widely divergent inflation expectations. ” References 1. Carbaugh, Robert (2006). Contemporary Economics: An Applications Approach. Cengage Learning. 2. Mankiw, Gregory (2008). Principle of Economics. Cengage Learning. 3. Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. 4. MANCOSA Economics Module, 2010

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