An industry said to be characterized by monopolistic competition is the apparel
ID: 1191891 • Letter: A
Question
An industry said to be characterized by monopolistic competition is the apparel industry. In May 2015, a Wall Street Journal article on apparel pricing began this way: “Remember all the nifty bargains you found shopping for clothes last year? So do retailers. And, they vow never again. For two years, stores have countered slowing demand for apparel – from sweats to cocktail dresses – with constant discounting, trying to spur demand by giving up profits. Now, after one of their least profitable years, big apparel merchants are ruling out another avalanche of sales and markdowns . . . They are developing an array of merchandizing gimmicks to wean shoppers off their addiction to deep discounts.”
Not surprisingly, this scenario sounds quite familiar, especially during the holiday seasons. The issue is whether monopolistic competitors can protect their profits. Suppose you were hired as a consultant by a firm in this industry. How would you advise the firm as to the levels of output, price, and advertising in order to protect their profits? What problems might the firm encounter?
Explanation / Answer
A monopolistic competitive industry is characterized by numerous buyers and sellers, and homogeneous products that are slightly differentiated.
A monopolistic competitive firm will maximize its profits by equating its marginal revenue with marginal cost, in contrast to a perfectly competitive firm that equates its price with marginal cost, in which case price equals the marginal revenue. But for a monopolistic competitive firm, price is not equal to marginal revenue.
An important aspect of monopolistic competition is advertising. The firms choose advertising as the driver of product differentiation, and in general the advertising elasticity of demand is positive: The higher the advertising expense, the higher the quantity demanded of the product. However, in order to keep its product differentiated, the firms need to incur regular advertising expense, which, in the long run, increase the long run average cost curve. As long as LRAC will remain below price, the firm will make a profit, but if LRAC exceeds price, the firm makes losses. If advertising cost pushes up the LRAC consistently, then the loss making firm exits the market.