1. Some Efficiency Aspects of Monopolistic Competition: Innovation, Variety and Transaction Costs
Tamara Todorova
Department of Economics
American University in Bulgaria
“Innovations in the Economy” Conference
New Bulgarian University
October 3, 2015
Sofia, Bulgaria

2. Major sins of monopolistic competition
excessive advertising
high selling costs
too much packaging
cross transportation
too much variety and lack of product standardization
too small or inefficient scale

3. The study of monopolistic competition in a historical perspective
Robinson (1933) and Chamberlin (1947) argue that imperfect competition causes inefficiency in economic organization by giving rise to excess capacity.
Tendency in neoclassical economics to emphasize the inefficiency of monopolistic competition at the expense of the cost- economizing effects and economies of scale of monopoly and oligopoly. Transaction costs ignored.

4. Aim of paper
to study some welfare aspects of monopolistic competition stressing its sustainability and efficiency compared to other market structures.
greater tendency for innovation
more variety provided at low cost
low transaction costs

5. Literature review
Robinson (1933) and Chamberlin (1947) introduce imperfect competition.
Harrod (1952) maintains that the entrepreneur will choose optimal scale.
Dixit and Stiglitz (1977) – when product diversity is accounted for, monopolistic competition is not suboptimal.
Demsetz (1982) argues that product differentiation, patents, trademarks and economies of scale create entry barriers because of the costs of information.

6. Literature review
Baumol (1964) - if the number of firms in the industry is reduced, the variety of products available to consumers must fall.
The resulting saving in resources is a net gain only if the total physical costs increase less than the increased choice for consumers.

7. General framework Flat D curve, low demand.
In monopolistic competition the assumption of free entry cancels the effect of product differentiation.
Product differentiation alone cannot provide market power to the individual firm.

9. 2. Monopoly under different cost structures

10. X-inefficiency
X-inefficiency and managerial slack associated with market power
Increased administrative and managerial costs
Greater potential for excess capacity

11. 3. Monopolistic competition versus X- inefficiency

12. Innovation
Failure to innovate and improve production technology causes inefficiency and excess capacity.
Except the efficiency of management a given LRAC curve reflects the level of technology.
A competitive firm would constantly strive to improve technology and lower its LRAC curve to prevent entry by competitors.
A monopoly has less incentive to adopt a new technology.

13. Innovation
Monopolistically competitive firms adopt cost- efficient and cost-reducing technologies.
Purpose is to prevent entry, respond to intense competition, or increase profit in an industry with a small profit-making potential.
The monopolistic competitor produces the greatest amount of output at the lowest price with minimum inefficiency.

14. Product variety
Industries with a high scale factor are those with few indivisibilities, small optimal scale of production, highly variable inputs, low setup costs.
Inputs can easily be scaled up or down to respond to market needs.
Fixed costs are insignificant in the short or medium run.
Monopolistically competitive markets are also contestable markets – lack of sunk or setup costs, easy entry and exit.

15. Product variety Variable costs are the costs of providing variety.
Supply is driven by fashion, market trends, changing styles, and customs.
Variety provided by variable inputs
Variable inputs – different colors, dyes, ingredients, components, moulds used to produce different models, sizes, shapes, styles, flavors, textures, etc.
Flexible technology

16. George Stigler on small firms and product variety
“… anyone who watches a line of automobiles start forward as a traffic light changes will be impressed by how each additional driver starts a little later than his predecessor… This same slack is encountered in large organizations... The industries making style goods (women’s apparel and shoes, novelty toys, and so forth) are consistently dominated my smaller and more flexible companies.”
Stigler, G. J. (1968). The Theory of Price, New York: Macmillan, 3rd edition, p. 156.

17. Learning by doing
By producing an identical product in large volumes and running repetitive processes monopoly and oligopoly experience falling cost curves and high learning curves.
A sole proprietor gains learning experience in adapting to change and specializes in rapidly changing styles, colors, shapes and models.
A diverse product is socially more important than a tedious, standardized one.

18. 4. Monopolistic competition with different degrees with product differentiation

19. Advertising Barrier to entry Part of the promotional mix
Differentiates the product
Acts as fixed cost for the firm
More intensely used by oligopoly

20. Transaction costs
Monopolistic competition as the true type of competition.
Perfect competition is unrealistic because 1) products can hardly be perfectly homogeneous; 2) the market power of the individual firm is never zero; 3) transaction costs are never zero in the real world.

21. Ronald Coase, 1937
Lower levels of transaction costs in some industries pair with smaller firms.
In high transaction cost industries large firms supersede the market mechanism.
Transaction costs act as fixed costs and increase optimal production scale.
Coase, R. H. The Nature of the Firm. Economica, New Series, Vol. 4, pp

22. 5. Optimal firm size with positive transaction costs

23. Monopolistically competitive markets
Information can be obtained at low cost.
Search takes less time and is easier.
Transactions cost less to organize relative to other real market structures.
Strong competition
Easy entry and exit

24. Monopolistically competitive markets
Little opportunism
Abundant information
Nearly perfect certainty
With positive transaction costs perfect competition is an unreal, theoretical construct.

25. Private monopoly Extreme market power Absence of competition
Contractual opportunism on the part of the monopolist
Costly information
High uncertainty
Natural or artificial barriers to entry

26. Conclusions
Based on innovation, variety and transaction costs as sources of inefficiency, monopolistic competition is the true type of competition, compared to the unrealistic perfectly competitive setup.
Monopolistic competition is an optimal form of resource allocation compared to monopoly or oligopoly.

27. Conclusions
It is better to speak of perfect monopolistic competition of just competition in economics.
The perfect competition benchmark should be dropped as a real type of market structure.