Last week I re-joined gym with Les Mills, as my previous fitness club (Revive) got shut down. The amenities provided and the corresponding higher price charged by Les Mills made two things come to mind:
- Why are the prices different between these gyms?
- Are they “extracting surplus” from me – in other words overcharging me?
To think about this, I want to talk about competition – specifically an idea called monopolistic competition.
What is monopolistic competition?
It is a market with a combination of monopoly and competitiveness, but with key distinctions. In monopolistic competition market there is a monopolistic firm and many substitute firms with low barriers of entry. In monopolistic competition, the price change of one firm doesn’t affect the price of another. Product differentiation is a key element of the market.
You would say that oligopoly and monopolistic competition overlap in many ways, however the main distinction in monopolistic competition is that there are very low barriers for the substitute firms to enter, where as in oligopoly the barriers are moderate/medium. Another difference is that if a firm sets different price in oligopoly, it makes other firms to react, whereas in monopolistic competition price changes by firms do not affect each other
What is monopoly and monopolistic competition then?
A monopoly is a market with a solo firm, where the barriers to entry are very high. A monopolistic competitive firm is ALSO a solo firm, but the barriers to entry of close substitutes are low.
The fact it is close – not perfect – substitutes is important. In this case if the firm increases its price it does not lose all of its customers, as a result in the short term the relative demand curves faced by the firm are given as follows.
In this case, due to the product being “different” in some way the demand curve faced by the firm varies from perfect competition. How could the product be different?
- Branding and perception of quality
- Trust in the machines offered in the gym
- A belief that having the Les Mills brand in your pocket will give you greater gains
- Tangible differences in the services/product offered
- Quality of gym machines
- Direct network effects (where my friends go)
These differences can also lead to differences in “costs”. But the price difference occurs because the differing gyms CAN charge different prices and without losing or gaining all of the customers in the market – in the case of perfect competition this would not occur.
So having close substitutes (what econs will call a market with heterogeneous goods) can help explain why Les Mills charges a different fee than my prior gym.
Costs and our monopolies
However, we haven’t worked out whether they are taking advantage yet. To figure that out we need to compare a monopoly with a monopolistically competitive firm.
If Les Mills is a monopoly, and would make “normal profits” if it was perfectly competitive, what can we say? From the lecture slides for introductory economics at Victoria University of Wellington comes the following graph:
The monopoly earns a margin above marginal cost and also receives supernormal profits – profits in excess of what is required to supply the market. Such profits are coming straight out of my consumer surplus!
The same type of argument would hold for a monopolistically competitive firm at face value. They will charge a “markup”, but does that imply they make supernormal profits too?
Lets go a step further.
The long run: Entry and exit
In case of monopoly when we introduced the average cost (AC) curve, we can see that, the firm sets prices that are higher than average cost (AC) which allows it to make a supernormal profits.
However, in monopolistic competition our “mini-monopolies” have some close competitors to the product they offer. Economists call these close substitutes. If these close substitute firms lower their prices, this shifts the demand curve to the left for the firm we are looking at, and we get a different intersection between AC and demand curve.
In this case, firms make normal profits only – as the close substitutes keep entering until all supernormal profits are gone. This is what the “low” barriers to entry refer to.
Graphically this would see the demand curve for the firms product shift to the left until it just touches the AC curve once – this is the point where economic profit is zero, and economic profit for all other levels of production will be negative.
With Les Mills are there close substitutes? In my view there is:
- Doing exercises outside or with groups of friends,
- The use of “exercise apps”,
- Other gyms which offer varying “quality-price” trade-offs,
- Other Les Mills!
Most importantly, if a Les Mills gym tried to set a higher price that would incentivise the entry of additional substitutes whose costs of entry are relatively low (outside group fitness classes, phone apps) leading to an enventual reduction in demand for Les Mills memberships.
To sum up my thoughts , I have recently joined Les Mills , a monopolistically competitive firm. There exist other substitute gym clubs in Wellington but the price charged by Les Mills is higher due to the better amenities it provides.