Can small firms, operating in a monopolistically competitive market be economically efficient?

 

1. 

Monopolistic competition as an idea is associated with Edward Chamberlin and Joan Robinson, who posited a realistic model of firms which operate in markets that change over time. Monopolistic competition has little to do with monopoly, except the monopoly of branding, patent, and trademark.

Monopolistic competition describes a situation in which firms offer differentiated products, which do not initially have substitutes in the minds of consumers. This allows for abnormal profits, because firms can control price or supply in such a way that production occurs where marginal revenue equals marginal cost, maximising profit because firms sell at a level of average revenue above average cost. 

In a monopolistically competitive market, however, barriers to entry for similar products are low and, whilst not perfect, knowledge and information cannot be fully restricted. Other firms therefore enter, with differentiated products or services that cater for the same need as the original whilst being slightly different in terms of branding; android challenges Apple, Nike challenges adidas, a curry house challenges a small town’s pizza parlour, and so on.

This process leads to lower revenues for the individual firms, and higher costs, particularly of advertising and marketing, as well as higher average costs if the firm sells fewer goods or services. Eventually, competition becomes so effective and the barriers so low that firms end up making normal or near-normal profits.

There are various sorts of economic efficiency. Because firms seek to maximise profits, the only market in which allocative and productive efficiency, at which firms produce where price equals marginal cost and where average cost is at its lowest point, is long-run perfect competition. In such markets, normal profits are made in the long run. However, firms with monopoly power can choose to produce at productive efficiency (lowest LRAC) where they are sales-maximising by producing where AC=AR. They could do this to maximise sales or to boost a complementary product, or to limit the market price in order to keep another firm out of the market. In the proper sense, this would not be rational in the long run, nor allocatively efficient. 

Firms which are monopolistically competitive will not be in perfect competition and will not rationally choose anything other than maximum profits, so they will be neither productively nor allocatively efficient. They will, however, be forced to be dynamically efficient by competition or go out of business if revenue sinks below variable cost.  They will be forced to cut out x-inefficiency and improve productivity, and the economy will therefore be moved to a more efficient position in theory.

Economics in 2022 does not simply focus on mathematical forms of efficiency. Pareto and Welfare efficiency, for instance, imply that economies might exist for the maximisation of normative outcomes. In Pareto efficiency, no one can be better off without others being worse off, and in welfare efficiency, all utilities are maximised. It could therefore be that some customers prefer small diverse providers to monocultures produced by efficient large ones.

Some customers, whose behaviour is treated as irrational because they value choice, staff conduct, stakeholder happiness, and the reassurance of habit, or who do not want to constantly switch the source of the good or service they buy for reasons of mental health or focus, might prefer smaller differentiated products even if they are slightly higher in price than they could be. It is also the case that many smaller businesses in monopolistic competition are owned by small traders or limited companies which are nearer to normal profit, and therefore efficiency, than many academic studies suggest.

This is because of the unclaimed time and effort which owners put into firms. Such firms, such as local food or coffee stores might also contribute positively to local society and carry with them much greater positive externalities than bigger companies which spend time colluding in oligopolies, avoiding taxes, or exploiting labour value whilst relying on corporate socialism in order to maximise the status of rent-seeking regional or corporate managers and directors.

Even such oligopolies, which might operate with monopolistic power locally but in a monopolistically competitive global market, could benefit society in the long run by being inefficient enough to make abnormal profits which then sustain research and development, or the careers of people who ultimately benefit society. Mainstream economics, which tends to elevate marginal utility and outcomes which can be measured mathematically, cannot generally justify such behaviour in general because its outcomes are speculative until they are realised.

Universities, for instance, sustain careers without measurable academic outcomes in between the training of graduates and the production in the form of teaching and works by professors. Sporting companies, like creative media, might inspire in the long run whilst entertaining in the short run. Both activities could raise costs without raising investment or be subject to dynamically falling revenues as others copy their activity, whilst maximising the welfare of a society or the mental health of individuals who enjoy or produce their product in the long run.

Economic efficiency could therefore relate to productive (technical), allocative, or dynamic efficiency and, in most models, monopolistic competition would not deliver greater efficiency unless the economy were transiting from a state one towards a market one. However, monopolistic efficiency could deliver greater welfare or Pareto efficiency if welfare or fairness were interpreted normatively rather than as the sum or product of utility.