1. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Chapter 14 Monopolistic Competition Monopolistic Competition

2. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition A monopolistically competitive industry has the following characteristics:A monopolistically competitive industry has the following characteristics: A large number of firms A large number of firms No barriers to entry No barriers to entry Product differentiation Product differentiation

3. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Characteristics of different market organizations No. of firms Product Differentiated or Homogenous Price a decision variable Easy entry Distinguished by Perfect Competition ManyHomo.NoYes No price competition MonopolyOne A single, unique product YesNo Still constrained by market demand Monopolistic Competition ManyDifferentiated Yes, but limited Yes Price and quality competition OligopolyFeweitherLimitedLimited Strategic behaviour

4. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition Monopolistic competition is characterized by a large number of firms, none of which can influence market price by virtue of size alone.Monopolistic competition is characterized by a large number of firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms producing differentiated products.Some degree of market power is achieved by firms producing differentiated products. New firms can enter and established firms can exit such an industry with ease.New firms can enter and established firms can exit such an industry with ease. However, they cannot influence market price by virtue of their size but due to differentiation in their product….hence good substitutes are available in such a market structureHowever, they cannot influence market price by virtue of their size but due to differentiation in their product….hence good substitutes are available in such a market structure

5. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Case for Product Differentiation and Advertising The advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power.The advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power. Product differentiation helps to ensure high quality and efficient production.Product differentiation helps to ensure high quality and efficient production. Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place.Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place.

6. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Case Against Product Differentiation and Advertising Critics of product differentiation and advertising argue that they amount to nothing more than waste and inefficiency.Critics of product differentiation and advertising argue that they amount to nothing more than waste and inefficiency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products.Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products.

7. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Case Against Product Differentiation and Advertising Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance.Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance. People exist to satisfy the needs of the economy, not vice versa.People exist to satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive warfare and may serve as a barrier to entry, thus reducing real competition.Advertising can lead to unproductive warfare and may serve as a barrier to entry, thus reducing real competition.

8. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Product Differentiation Reduces the Elasticity of Demand Facing a Firm Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.

9. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Short Run In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC. (the behavior is same as in case of a monopoly firm)In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC. (the behavior is same as in case of a monopoly firm) This firm is earning positive profits in the short- run.This firm is earning positive profits in the short- run.

10. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Short-Run Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses. The firm must be able to cover the variable cost or else it will shut down and incur loss equal to fixed costProfits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses. The firm must be able to cover the variable cost or else it will shut down and incur loss equal to fixed cost

11. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Long-Run As compared to perfect competition, the long run behavior is somewhat different in monopolistic competition because a firm that enters a monopolistically competitive industry will produce a close substitute for the good in question, but not the same good.As compared to perfect competition, the long run behavior is somewhat different in monopolistic competition because a firm that enters a monopolistically competitive industry will produce a close substitute for the good in question, but not the same good. We begin our analysis assuming that positive profits are earned by a monopolistic competitive firm which acts as an incentive for new firms to enter the industryWe begin our analysis assuming that positive profits are earned by a monopolistic competitive firm which acts as an incentive for new firms to enter the industry

12. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Long-Run The firm’s demand curve must end up tangent to its average total cost curve for profits to equal zero. Also MR=MCThe firm’s demand curve must end up tangent to its average total cost curve for profits to equal zero. Also MR=MC This is the condition for long-run equilibrium in a monopolistically competitive industryThis is the condition for long-run equilibrium in a monopolistically competitive industry

13. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Long-Run The tangency occurs at the profit maximizing level of output, i.e., where MR=MC.The tangency occurs at the profit maximizing level of output, i.e., where MR=MC. This also means that at any other level of output, ATC will lie above the demand curve.This also means that at any other level of output, ATC will lie above the demand curve. Hence at the point of tangency, ATC= Price and Profits=0.Hence at the point of tangency, ATC= Price and Profits=0. What happens when demand curve crosses ATC intersecting at 2 points????What happens when demand curve crosses ATC intersecting at 2 points???? What happens when demand curve is below the ATC???What happens when demand curve is below the ATC??? LONG RUN EQUILIBRIUM WILL REMAIN SAME IN ALL CASES; demand curve being tangent to ATC.LONG RUN EQUILIBRIUM WILL REMAIN SAME IN ALL CASES; demand curve being tangent to ATC.

14. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Efficiency and Resource Allocation In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however, there are two problems:In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however, there are two problems: Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product. Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product.

15. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Efficiency and Resource Allocation Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity. Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity.