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1 eonstor Make Your Publiations Visible. A Servie of Wirtshaft Centre zbwleibniz-informationszentrum Eonomis Todorova, Tamara Preprint Some Effiieny Aspets of Monopolisti Competition: Innovation, Variety and Transation Costs Suggested Citation: Todorova, Tamara (2016) : Some Effiieny Aspets of Monopolisti Competition: Innovation, Variety and Transation Costs, ZBW - eutshe Zentralbibliothek für Wirtshaftswissenshaften, Leibniz-Informationszentrum Wirtshaft, Kiel und Hamburg This Version is available at: Standard-Nutzungsbedingungen: ie okumente auf EonStor dürfen zu eigenen wissenshaftlihen Zweken und zum Privatgebrauh gespeihert und kopiert werden. Sie dürfen die okumente niht für öffentlihe oder kommerzielle Zweke vervielfältigen, öffentlih ausstellen, öffentlih zugänglih mahen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die okumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweihend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrehte. Terms of use: ouments in EonStor may be saved and opied for your personal and sholarly purposes. You are not to opy douments for publi or ommerial purposes, to exhibit the douments publily, to make them publily available on the internet, or to distribute or otherwise use the douments in publi. If the douments have been made available under an Open Content Liene (espeially Creative Commons Lienes), you may exerise further usage rights as speified in the indiated liene.

2 SOME EFFICIENCY ASPECTS OF MONOPOLISTIC COMPETITION: INNOVATION, VARIETY AN TRANSACTION COSTS Tamara Todorova Amerian University in Bulgaria Abstrat: We stress some effiieny aspets of monopolisti ompetition justifying it on aount of its tendeny to innovate and the questionable exess apaity paradigm. Some further effiieny aspets revealed are produt variety and transation ost savings. We view the monopolistially ompetitive firm as an essential soure of tehnologial innovation, produt variety and ost eonomies. While perfet ompetition is universally onsidered a benhmark and a soial optimum, we onsider it a strongly unrealisti theoretial setup where the monopolistially, rather than the perfetly, ompetitive firm turns out to be the true type of ompetition and soial optimum in the real world of positive transation osts. The monopolistially ompetitive firm not only offers produt variety and innovation but is the optimal institutional arrangement under positive transation osts. Key words: effiieny, innovation, variety, monopolisti ompetition, perfet ompetition, transation osts JEL lassifiation: 23, 24, 43, L13, O3 Introdution It is often onsidered that large orporations are the main soure of innovation and sientifi disoveries due to their size and ability to fund expensive researh. Small ompetitive firms are rarely onsidered innovative due to their smallness and the fat that their low profits prevent them to invest in innovative projets. A sole proprietor has a vested interest in hanging the tehnology, introduing some novelty and eventually outstripping ompetition. The inentive struture of firms is thus ignored and the fous instead is put on funding and investment opportunities. This paper justifies monopolisti ompetition on aount of the tendeny to innovate revealing some further effiieny aspets suh as produt variety and transation ost effiienies. We view the monopolistially ompetitive firm as an essential soure of 1

3 tehnologial innovation, produt variety and ost eonomies. While the perfetly ompetitive firm remains an unrealisti type of market struture, the monopolistially ompetitive one turns out to be the true type of ompetition whih gravitates most losely to the soial optimum. The monopolistially ompetitive firm is not only strongly entied to introdue produt variety and innovation but is the optimal institutional arrangement under positive transation osts. Some eonomists doubt the effiieny of monopolisti ompetition. Many find it suboptimal due to its exessive advertising, high selling osts, unneessary and exessive pakaging. Some of these sins of monopolisti ompetition an be questioned. For instane, the advertising undertaken by the monopolistially ompetitive firm is modest due to the lak of budget opportunities and the few firms whih advertise a highly differentiated produt turn into an oligopoly in their setor. The fiere ompetition fores monopolistially ompetitive firms to lower their prodution and marketing osts onsistently. Cross transportation is another ausation but a produt whih onsumers view as essentially different and useful has to ross borders in order to satisfy their needs. ifferentiated produts move from one plae to another following the simple eonomi priniple that eonomi resoures move to plaes where they are valued the most. Thus what seems as unneessary and exessive transportation may turn out to be a valuable feature of monopolistially ompetitive produts. Some sholars go as far as ritiizing monopolisti ompetition for the lak of produt standardization and, hene, for providing too muh variety. The bias against monopolisti ompetition originates from the very founders of miroeonomi siene and industrial organization, Robinson (1933) and Chamberlin (1947). They argued that imperfet ompetition auses ineffiieny in eonomi organization by giving rise to exess apaity. The very word ineffiieny was attahed to monopolisti ompetition sine the ineption of the term and has turned into one of its key attributes ever sine. Monopolisti ompetition was ondemned in part due to its small size whih did not provide for large-sale prodution and, therefore, a standardized produt. The ost-eonomizing effets and sale eonomies of market strutures with market power were emphasized instead and monopoly and oligopoly were justified on the grounds of sale effiieny. Generally there is a tendeny in miroeonomi theory to stress sale and the size of prodution muh more than produt use and value, onsumer utility, produt variety and transation osts. The latter are ignored in neolassial analysis where in the presene of low transation osts monopolistially ompetitive firms provide for most intense ompetition. 2

4 This paper aims to study some welfare aspets of monopolisti ompetition stressing its sustainability and effiieny ompared to other market strutures. More speifially, it maintains that monopolistially ompetitive firms are more likely to adopt innovative methods of prodution, while providing greatest variety possible at the lowest prodution and transation osts. Literature review Robinson (1933) and Chamberlin (1947) introdued the term imperfet ompetition. In his disussion of the small-group ase and the large-group ase denoting monopolisti ompetition and oligopoly, respetively, Chamberlin seemed onfused about the two. While trying to distinguish between them he onsistently attributed oligopoly, that is, monopoly features to monopolisti ompetition. For instane, he saw market power as a onsequene of produt differentiation, as represented by a steep demand urve, but, at the same time, assumed free entry in the industry, as demonstrated by the tangeny of the firm s demand urve and its long-run average ost urve. Obviously, these two annot o-exist and a firm with exessive market power is likely to fae both a very steep and extended demand urve whih reates a high profit-making potential. Competitive firms, on the other hand, are learly subjet to very flat and very low demand urves whih bring the potential for exess apaity to a minimum. Monopolisti ompetition demonstrates that the assumption of free entry anels the effet of produt differentiation and that produt differentiation alone annot provide market power to the individual firm. Barriers to entry, natural or artifiial, are needed to ensure monopoly position for the individual firm. Chamberlin also seemed to be onfused about the advertising the small-group and the large-group undertake. He saw the monopolistially ompetitive firm as aggressively advertising whereas that is rather a feature of huge orporations in oligopolisti industries where exessive promotional and advertising wars result in devastating losses for both the firms and soiety. On the ausation of exess apaity Harrod (1952) has argued that the entrepreneur will hoose optimal sale for a small ompetitive firm and not one whih will leave too muh idle apaity. In their model of monopolisti ompetition ixit and Stiglitz (1977) found that, produt diversity added, monopolisti ompetition is an optimal market struture, irrespetive of the lak of sale eonomies. emsetz (1982) has argued that produt differentiation, patents, trademarks and eonomies of sale reate entry barriers beause of the osts of information. Monopolistially 3

5 ompetitive firms thus operate under low osts of information although produts have differentiated features. Baumol (1964) maintains that if the number of firms in the industry is redued, the variety of produts available to onsumers must fall. The resulting saving in resoures is a net gain only if the total physial osts inrease less than the inreased hoie for onsumers. Arrow (1962) demonstrates that a ompetitive firm is more likely to innovate than a monopoly beause it has more to win than the monopoly. The marginal benefit or revenue of innovation for the monopolist is insignifiant while, if the same innovation is undertaken by a ompetitor, he will reap muh of the industry profits driving all other rival firms in the setor out of business. The ompetitor, therefore, has stronger inentives to innovate than a firm with market power. The effiieny of monopolisti ompetition X-ineffiieny and managerial slak are perhaps most illustrative of the advantages of monopolisti ompetition over other market strutures. ue to their market power and lak of ompetitive threats, monopoly and oligopoly are subjet to inreased administrative and managerial osts whih shift the average ost of the firm up to the level of Competitive firms operate at low long-run average ost urves suh as m, as in Figure 1. and are, therefore, deprived of X-ineffiieny. This type of ineffiieny an take on various forms in monopolisti firms rent-seeking ativities, wasteful use of resoures, poor organization and oordination of prodution, poor treatment and oordination of human resoures, all kinds of managerial malpratie, managerial slak in the form of unneessary managerial perks, rent extration by managers at the expense of owners and all adverse effets on ownership resulting from the prinipal-agent problem. p m m q Figure 1. Monopolisti ompetition versus the X-ineffiieny of monopoly 4

6 Firms whih fail to innovate and improve their prodution tehnology are also likely to fae a higher urve and, therefore, exess apaity. Exept the effiieny of management, a given urve reflets the level of tehnology used in the prodution proess. A ompetitive entrepreneur would be entied to onsistently improve tehnology, lower average osts and prevent entry. A monopolist has less inentive to lower his urve and adopt a new, improved tehnology idential to what Figure 1 shows. Failure to innovate auses ineffiieny in the form of exess apaity at the same level of demand for the firm s produt. Monopolistially ompetitive firms improve their prodution tehnologies with the aim to prevent entry, respond to existing ompetition by inumbents or expand profit in an industry with a modest profit-making potential. Proprietors hoose tehnologies and tehnial proesses whih are ost-effiient, ost-reduing or expanding the prodution set of the firm at the respetive level of fator usage. Faed with a lower average ost urve the proprietor is able to beat ompetition on prie, lower than that of the monopolist. A monopolisti ompetitor harges the lowest prie and produes the greatest prodution volume at minimum ineffiieny possible. Monopoly and oligopoly are known for their indivisibilities when it omes to prodution fators. Indivisibilities do not allow saling prodution up or down in response to hanges in market demand. These tehnologial peuliarities perhaps lie at the basis of market power sine firms have to operate at a large sale in order to handle indivisible fators of prodution. This also determines the existene of few firms in the industry. Exept indivisibilities sale eonomies originate from sizable fixed osts, setup osts, speialized inputs, volumetri returns to sale, et. In addition to substantive fixed and setup osts, large firms are subjet to signifiant administrative osts whih represent a share of the fixed osts of the firm. There are few or no indivisibilities of prodution in monopolisti ompetition. These are industries with a high saling fator where all fators of prodution an easily be saled up or down and fixed osts are almost non-existent in the short run. Setup osts of prodution are low whih failitates entry. Optimal sale of prodution is rather small with inputs being highly variable. Variable inputs prevail over fixed ones. The absene of sunk or setup osts haraterizes these as ontestable markets with both easy entry and exit. In ontestable markets reoverable osts allow using inputs in alternative ways. Marketing, advertising, administrative and managerial osts are minimal in monopolistially ompetitive firms. Mahinery is generalpurpose and inexpensive, while labor is unspeialized. 5

7 In selling differentiated produts monopolisti ompetitors are often driven by fashion, rapidly hanging styles, tastes, ustoms and trends. Providing variety is not possible without a signifiant variable omponent. Inputs suh as different olors, dyes, ingredients, omponents or moulds neessary to produe different models, sizes, shapes, styles, flavors, textures, et. are primarily variable inputs. The osts of providing variety thus are mostly variable osts and variety and produt differentiation result from the use of variable inputs. It is variable inputs and flexible tehnology that shape the ost struture of firms in ompetitive industries. Stigler (1968, p. 156) believes that large orporations are lumsy at providing variable, trendy produts and small firms are more flexible in produing ommodities suh as women s apparel and shoes, novelty toys, et. It seems, therefore, that variety originates from variable, rather than fixed, inputs and variety alone is a unique ontribution of monopolisti ompetition at best and of oligopoly at worst. At the same time, monopoly and oligopoly whih operate standardized equipment and run repetitive proesses experiene high learning urves of idential prodution. Unit osts of prodution drop with every suessive bunh of items produed. A sole proprietor annot ahieve ost eonomies on the basis of repetition in that prodution proesses are non-standardized, unique, and subjet to hange. Prodution hanges with every new olor, trend, item or model on style. The sole proprietor though gains learning experiene in adapting to hange, something the operational managers of big orporations annot take pride in. While monopoly and oligopoly speialize in sameness and standardization, monopolisti ompetition speializes in variety. p MES q Figure 2. Monopolisti ompetition with different degrees of produt differentiation Many essential produts people onsume today ome from uniform, monopolisti-type prodution. But undoubtedly many soially important produts originate from ompetitive industries as well. A diverse produt is soially more important than a tedious, standardized one. The monopolistially ompetitive firm provides highly useful, valuable produts with high 6

8 marginal utility for soiety at relatively low ost and without the wasteful effet of exessive advertising. As part of the promotional mix of the large firm advertising serves as a barrier to entry by differentiating the produt, as in Figure 2, and ats as fixed ost for the firm. This last outome is often ignored when disussing advertising (Figure 3). p o MES MES Figure 3. An advertising oligopoly q The effet of transation osts on the total osts of the individual firm is idential to that of advertising. Transation osts, defined as the osts of market operation or rather market substitution by firm management (Coase, 1937), at as fixed osts whih inrease the optimal prodution sale similarly to advertising. Both advertising and additional transations add a ost omponent to the firm struture and thus shift the total ost urve up (Figure 4). p m transation osts MES MES q Figure 4. Optimal firm size under positive transation osts Note however that in both ases sine a fixed ost is added to total ost the minimum effiient sale, that is, the optimal sale of operations is inreased sine large firms supplant high transation osts and operate in industries with signifiant risks of market operation, they are likely faed with a substantive inrease in the optimal sale of operation, muh beyond the point of soial optimum under zero or negligible transation osts. 7

9 Transation osts are never zero in the real world. Coase (1937), Williamson (1979), Eggertsson (1999) and others have long stressed that transation osts do exist and affet the behavior of eonomi agents. Williamson (1989, p. 227) has gone as far as laiming that different types and levels of transation osts bring about different types of institutional arrangements, firms and market organization. Coase (1937) has maintained that lower levels of transation osts pair with smaller firms, while larger firms supersede the market mehanism in ases when the transation osts of its operation are substantive. The manager undertakes to do more and more transations and perform the funtions of the market as he saves on the osts of using market organization alternatively. What is the role of monopolisti ompetition in this? Competitive markets are those where transation osts are positive, yet, negligible. The degree of ompetitiveness is illustrative of the ease with whih information an be obtained. It is believed that in perfetly ompetitive markets partiipants both on the demand and the supply side obtain information at zero ost and are thus fully informed. Information about pries, quality levels, number and type of buyers and sellers, et. is abundant and the level of ertainty is infinite. In this ideal world of perfet ertainty and information it is hard for anyone to take advantage of another. Quality annot be misrepresented and no form of heating an our. It seems that the soial optimum, as implied by the perfetly ompetitive model, is one of honesty and fairness. However in reality no suh perfet world an exist where eonomi agents are perfetly honest. This renders the perfetly ompetitive framework unrealisti. In real terms information is never perfetly abundant and aessible (often it is even sare) and eonomi agents are sometimes suseptible to all forms of market opportunism. We an, therefore, onlude that perfet ompetition is an unrealisti assumption on aount of three premises, 1) that produts an hardly be perfetly homogeneous in reality; 2) that the market power of the individual firm is hardly ever zero; and 3) that transation osts are always positive in the real world. Industries whih operate under low transation osts are usually strongly ompetitive, without being perfetly so, entry and exit are easy, there is little opportunism on the part of market partiipants, information flow is free and unertainty is low. High-transation ost setors are those where signifiant barriers to either entry or exit exist, ompetition is low, if none, information is sare and unertainty is infinite. 8

10 Monopolistially ompetitive markets tend to be markets where information an be obtained at low ost and transations take less to organize. Sine information is easy to get, the potential for opportunism is minimal. Searh takes less time and is usually easier. Transations take less to organize ompared to other forms of market struture. Monopolistially ompetitive markets thus are real-life markets where transation osts are positive, yet, minimal. They present themselves with strong ompetition, easy entry and exit, little opportunism, aessible and abundant information and nearly omplete ertainty. Under positive transation osts, monopolisti ompetition is the true form of ompetition, while perfet beomes an ideal, hypothetial and unrealisti benhmark. Monopolisti ompetition illustrates best the inonsisteny and abstratness of perfet ompetition as a form of eonomi organization and a resoure alloation system. Monopolisti ompetition stresses best the impossibility of perfet ompetition in real life. At the same time, other market strutures whih present themselves with high market power gravitate around the seond type of market organization where ompetition is absent, there is great potential for unertainty and ontratual opportunism on the part of the firm with market power, information is ostly to obtain and there are natural or artifiial barriers to entry. Market power turns into an essential soure of opportunism sine it is diffiult for numerous ustomers to handle an opportunisti monopolist or, alternatively, diffiult for numerous suppliers to handle an opportunisti monopsonist. A result of market failure, monopoly power originates in transation osts, with transation osts being low in monopolistially ompetitive markets and high in monopoly and oligopoly. Monopolisti ompetition, therefore, is the true type of ompetition in the real world, a situation whih provides for optimal alloation of eonomi resoures, sine it reflets the soial optimum at positive, yet minimal, transation osts. Conlusion Based on innovation, variety and transation osts as soures of ineffiieny, monopolisti ompetition has advantages over market strutures with market power. Compared to monopoly and oligopoly monopolisti ompetition is more likely to adopt innovative tehniques of prodution, provide wide variety of goods and save on transation osts. Although deprived of repetition a sole proprietor easily speializes and experienes a high learning urve in providing variety. In the real terms of positive transation osts, monopolisti ompetition omes out as the true type of ompetition, ompared to the unrealisti perfetly ompetitive setup. 9

11 Referenes 1. Arrow, K. J. (1962). Eonomi Welfare and the Alloation of Resoures for Invention in The Rate and iretion of Eonomi Ativities: Eonomi and Soial Fators, Rihard Nelson, ed., Prineton University Press, pp Baumol, W.J. (1964). Monopolisti Competition and Welfare Eonomis. The Amerian Eonomi Review, 54(3), Papers and Proeedings of the Seventy-sixth Annual Meeting of the Amerian Eonomi Assoiation, (May, 1964), pp Chamberlin, E.H. (1947). The Theory of Monopolisti Competition, Cambridge: Harvard University Press, 5 th ed. 4. Coase, R.H. (1937). The Nature of the Firm. Eonomia, New Series, 4, pp emsetz, H. (1982). Barriers to Entry. The Amerian Eonomi Review, 72, pp ixit, A.K and Stiglitz, J.E. (1977). Monopolisti Competition and Optimal Produt iversity. The Amerian Eonomi Review, 67(3), pp Eggertsson, T. (1999). Eonomi Behavior and Institutions. Cambridge University Press. 8. Harrod, R.F. (1952). Theory of Imperfet Competition Revised. Eonomi Essays. 9. Robinson, J.V. (1933). The Eonomis of Imperfet Competition. London: Mamillan, 2 nd edition, Stigler, G.J. (1968). The Theory of Prie, New York: Mamillan, 3 rd edition. 11. Williamson, O.E. (1979). Transation-ost Eonomis: the Governane of Contratual relations. Journal of Law and Eonomis, 22, pp Williamson, O.E. (1989). Book Review for The Firm, the Market and the Law. California Law Review, 77, pp