Unlike the short run, in the long run, firms are able to enter and exit the market. New firms enter the market in response to the presence of economic profits, and old firms exit the market in response to losses. To continue the doughnut example from the last section, consider how in light of the New Zealand research, economic profits in the glazed doughnut industry would attract new firms to the industry. As new firms enter, competition increases, which means that the industry supply of glazed doughnuts increases. The increased supply reduces the equilibrium price of doughnuts and economic profits disappear.
Considering the California research, in the face of economic losses, some firms will reach the shutdown point and withdraw from the industry. This reduces competition and decreases the industry supply of glazed doughnuts. Decreased supply increases the equilibrium price in the market. In the end, fewer firms remain as the industry returns to its long-run equilibrium with zero economic profits.
Perfect competition does not really exist. It is unlikely that you will find an industry in which all of the conditions for perfect competition are met. However, perfect competition provides an example with which to compare the market structures that do exist. Although it isn’t real, it provides a nice frame of reference.
The continuum of market structures can be seen as an evolution of markets. Firms may begin in a very competitive market and over time become monopolists. The late nineteenth and early twentieth centuries witnessed the rise of the trusts from once-competitive industries. Some even called for an end to “ruinous competition.”
Most firms face barriers to entry, either in terms of cost or government requirements. Firms rarely deal in identical products, as they invest heavily in differentiating themselves from the competition. This ability to differentiate gives firms some ability to affect prices. In mature markets like the United States, firms tend to be large and not necessarily independent. Finally, access to information is not equally shared, and as a result, the condition of perfect information does not exist either. What you are left with is not perfect competition, but imperfect competition.
Economists classify markets according to their level of competition. On one end of the spectrum lie perfectly competitive, albeit fictional, markets. On the other end of the continuum lies monopoly. In between you will find the market structures that are most familiar, monopolistic competition and oligopoly.
Monopolistic competition is a market structure very similar to perfect competition. There are many buyers and sellers, barriers to entry are minimal or at least equal for all firms, and information is readily available. However, in monopolistic competition, firms do not offer identical products, but differentiate their products from those of their competition. Product differentiation is the process by which producers are able to convince consumers that their particular product is different from other producers’ products.
The industry that should come to mind when you think of monopolistic competition is fast food. The fast-food industry has many different producers competing for the dollars of many different consumers. All are welcome to start a fast-food restaurant as long as they pay the required licenses. Most producers have a good idea of what they are getting into and customers tend to understand the products quite well. Why is fast food monopolistically competitive? Product differentiation. Each firm offers a different menu. Taco Bell, Chick-fil-A, McDonald’s, and Subway all compete against each other in the fast-food market while providing customers with a variety of choices. Product differentiation is one of the reasons that new entrants are able to survive in this cutthroat industry. If you are different enough, then you might have a chance.
Next time you are in the produce section of the grocery store, take a look at how many varieties of apples are available. Do you remember the days when apples were either red or green? Today there are Red Delicious, Pink Lady, Granny Smith, Gala, Fuji, and Honeycrisp, to name a few. In addition, there are small, medium, and large. There are organic and pesticide-treated. Some are sold individually and some are packaged. Apple producers have differentiated their products. Why? Remember how competitive firms were unable to influence price? When producers differentiate their products and are successful, they are able to charge a higher price than their competition.
Can monopolistically competitive firms maintain economic profits in the long run? No. Over time, the presence of competition will eventually erode the monopolistically competitive firm’s profits. The end result is an industry with excess capacity, high cost, and no economic profits.
The problem with product differentiation is that it becomes a never-ending process. Firms must continually find ways to differentiate. This explains why firms will spend large sums of money on advertising. Much of the advertising is not so much an attempt to gain new customers as it is an effort to build brand loyalty. However, firms have limited resources, so engaging in product differentiation through advertising means that resources used in advertising are no longer available for production. As a result, industries that are monopolistically competitive do not produce as much output as they could if they were perfectly competitive. Consumers are missing out on what could have been. Not to worry, it seems that consumers have a strong preference for the variety that monopolistic competition brings, and so the benefits may at least equal the costs.