Entry Barriers to Monopolistic Competition-Free-Samples for Students

Questions: 1. What are the conditions that create barrier to entery for the new firm under monopolistic competition? What is the economic rationale for creating monopoly ( for specified period ) by granting patent to a firm? 2. What do you understand by asymmetric information? What imbalance does it create in the market for the used goods ? Answers: 1.Entry barriers to monopolistic competition In the monopolistically competitive market there are usually low barriers to entry. New firms can enter if the market seems profitable to them. However, there are situation that may restrict entry of new firms. If the incumbent firms exploit considerable economies of scale, then new entrants are unable of compete with the existing firms and this deters entry. Presence of network effect is another thing that prevents entry. When there are high set up cost most of which are sunk costs then firms do not enter (Nikaido 2015). Sunk costs are cost that cannot be recovered and exists in the form of advertising cost, cost for marketing and other types of fixed costs. Patent and Monopoly Patent is sole ownership right granted by the government for a specific period. The government by granting patent creates monopoly for welfare of the society. Paten enhances technological innovation by giving additional edge to the innovators over its competitors. Technological innovation requires large scale investment. If the new good invented is sold at the competitive price, then it would take a long time to recover the fixed cost. The patented goods are considered as lawful monopoly created with States interest to encourage creation of such goods (Longley 2013). Patents are mostly granted for goods that involve huge fixed cost. For example, pharmaceutical drugs. The pharmaceutical firms would not make invention of new drugs if they fail to receive sufficient return to recover costs. Patent is the mechanism that enables producers to recover their fixed production cost. Asymmetry information and market for used goods Complete information to all the agents is a pre-condition for competitive market. When there are discrepancies in the distribution of information of a commodity among buyers and sellers then then the information set is considered asymmetric (Donnelly, Englund and Nielsen 2014.). There are imbalances in market because of information asymmetry. Consider for example the market for used cars. In such market, there are some cars are of good quality while others are of low quality. If there are transparency in information about the cars quality, then there should be two separate markets foe each of the two qualities. Figure 1: Market for used cars (Source: Pindyck and Rubinfeld 2015) Figure 1 describes the market for used cars. DH and SH denote the demand and supply curve of high quality cars. Corresponding price for high quality cars is PH and quantity sold is NH. The demand and supply condition for low quality cars are indicated as DL and SL respectively. Equilibrium price for low quality cars is PL and number of low quality cars sold is NL. From the figure it is seen that NH=NL and PHPL. However, the buyers cannot distinguish between the two qualities because of asymmetry information and therefore willing to pay some price in the midway of PH and PL. This is reflected by the new demand curve D1. As the new demand curve reduces price of high quality cars to PH1 while raises that of low quality cars to PL1, the market now left with more low-quality cars. This further reduces peoples willingness to pay in the market and demand curve continued to shift leftward. Ultimately prices are reduced so much that only poor-quality cars are offered in the market. References Donnelly, C., Englund, M. and Nielsen, J.P., 2014. The importance of the choice of test for finding evidence of asymmetric information.ASTIN Bulletin: The Journal of the IAA,44(2), pp.173-195. Longley, N., 2013. Introduction. InAn Absence of Competition(pp. 1-7). Springer, New York, NY. Nikaido, H., 2015.Monopolistic Competition and Effective Demand.(PSME-6). Princeton University Press. Pindyck, R.S. and Rubinfeld, D.L., 2015. Microeconomics; Eight Edition, Global Edition.