ECON6001 Economic Principles- Monopolistic Competition

Economists would argue that each of these cafés enjoys a degree of monopoly power which is o?set by a degree of competition as well. Discuss the nature of these competitive forces in the context of a typical café and then explain the theoretical cost and revenue profile of a typical café which gives rise to any profitability it may enjoy in the short run.

What factors threaten the long-­ run profitability and survival of such a cafe?  Explain your answer.

If you walk down the street at lunch time you will notice that some cafes are filled to capacity with customers whereas others have spare seats. What are the implications of this for the minimization of a café’s long-­run average costs? Can you explain the reasons for this in the context of the 'excess capacity theorem' associated with the model of monopolistic competition?

Part 1

The cafe business is monopolistically competitive. Product differentiation provides the firm some extent of monopoly power. Presence of large number of cafes in the market makes the market competitive. Cocolat Rundle St is an established café of Rundle Street if Australia. The competitors of this firm are Eros Kafe, Exchange Specialty Café, Belgian Beer Café, The Coffee Club Adelaide Central and others. Each of the café gives tough competition to its rivals. Price competition is not profitable in the competitive market, hence café firm compete with each other through product differentiation. The competition in the market is imperfect as there is incomplete information to the customer regarding the product (Zhelobodko et al., 2012). Therefore, firms can charge the price according to their average revenue rather than marginal revenue.  

                                                            Figure 1: Short run revenue and profit of a Café

                                                                           (Source: created by author)

As presented in figure 1, short run equilibrium is achieved at the point E, where the marginal cost intersects the marginal revenue curve. As the cafe has some extent of market power to determine price and to attract customers, price is amount of products and services are determined according to the equilibrium point, however, price is set as per average revenue of the firm (Nikaido, 2015). The revenue from the production is the area OPBQ. The SRAC of production determines the SR profit of the firm.

A Rundle Street Café may incur SR profit or loss. If the total revenue is less than total cost, firm incurs loss. The figure 1 indicates SR profit as the price line is above the ATC curve. Total cost of the firm in providing service to the customers is OCDQ. Total profit of the firm is OPBQ – OCDQ = PCDB. Short run costs of the café are raw materials, daily maintenance, electricity cost and part time labour cost. Other factors such as investment for developing infrastructure, technology development cost are the long-term cost that has no such effect on short-term profit (Baumol & Blinder, 2015). When an existing firm earns short-term positive profit, external firms enter into the market. Entry and exist is costless in the monopolistically competitive market. As the customers get close substitute for their desired services, demand curve faced by café is elastic in nature. Price increase has little effect on the customer if the brand value of the café is high in the market through their product and services.

Part 2:

A positive profit in the market induces new firms to enter into the market. Allocation of the existing firm diminishes with ingress of the new firm in the market. Price in the market falls as the supply of goods and services increases. Subsequently revenue and profit decreases. If the price is reduced below average variable cost, café fears of long run loss in the market. A monopolistically competitive café needs to reduce its cost structure and unwanted costs to sustain in the market in the long terms as new firm having low cost can capture the market share easily using greater capacity (Nicholson & Snyder, 2012).

Part 3:

Availability of spare seats in the café signifies excess capacity of the firm. Under excess capacity, firm operates at the falling portion of the long run average cost curve. This is the optimal equilibrium point as the LRAC curve meets the demand curve of the firm. At the falling region of the LRAC firm enjoys economies of scale and hence, average cost of production decreases with the increase in production (Rader, 2014). Resources are not fully utilized at this segment.

                                                                                 Figure 2: Excess capacity

                                                                                (Source: created by author)

In figure 2, firm maximizes profit at point E, where MR = MC. In the long run, firm earns excess profit, hence, operating with excess capacity is feasible. Point A is the most efficient point, as it is the minimum point of the LAC curve. This point gives the firm super normal profit at price, ‘P’.  QQ* is the amount of excess capacity. In figure, D is the proportional demand curve of the monopolistically competitive firm. The firm, which has excess capacity, can increase output in long run. Firms use excess capacity to supply less than socially optimally output compared to perfect competitive. Moreover, price is less at the lowest point of LRAC curve. Firms use product differentiation, advertisement to capture the market (Baumol & Blinder, 2015). The amount of the excess profit reflects the advertisement and other social media advertisement cost to gain some monopoly power in the market.

The café, which has spear space, can maximize profit by utilizing smaller space. Better café service, product innovation, customer satisfaction make the demand curve inelastic. This firm has option to utilize the free space for other productive usage to maximize profit. The firm, which has filled, has limited scope to use capacity further. In order to enhance capacity, café has to invest further.

References

Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Cengage Learning.

Nicholson, W., & Snyder, C. M. (2014). Intermediate microeconomics and its application. Cengage Learning.

Nikaido, H. (2015). Monopolistic Competition and Effective Demand.(PSME-6). Princeton University Press.

Rader, T. (2014). Theory of microeconomics. Academic Press.

Zhelobodko, E., Kokovin, S., Parenti, M., & Thisse, J. F. (2012). Monopolistic competition: Beyond the constant elasticity of substitution. Econometrica, 80(6), 2765-2784.