1. © 2007 Thomson South-Western

2. Monopolistic Competition Characteristics: –Many sellers –Product differentiation –Free entry and exit –In the long run, profits are driven to zero

3. © 2007 Thomson South-Western Monopolistic Competition Free Entry or Exit Firms can enter or exit the market without restriction. The number of firms in the market adjusts until economic profits are zero.

4. © 2007 Thomson South-Western What does the costs graph for one of these firms look like?

5. © 2007 Thomson South-Western The Monopolistically Competitive Firm in the Short Run Two things can happen A firm could experience economic loss A firm could experience economic profit

6. © 2007 Thomson South-Western What if a firm is earning profit?

7. © 2007 Thomson South-Western Figure 1 Monopolistic Competition in the Short Run Quantity 0 Price Profit- maximizing quantity Price Demand MR ATC (a) Firm Makes Profit Average total cost Profit MC

8. © 2007 Thomson South-Western Short Run Profits Encourage new firms to enter the market. This: –Increases the number of products offered. –Reduces demand faced by firms already in the market. Demand curves shift to the left. Profits decline.

9. © 2007 Thomson South-Western In the long run, firms will continue to enter the market until a firm’s economic profit is driven to zero…

10. © 2007 Thomson South-Western Figure 2 A Monopolistic Competitor in the Long Run Quantity Price 0 Demand MR ATC MC Profit-maximizing quantity P =ATC When profit is earned, firms will enter the market until profit is driven to zero And this tangency lies vertically above the intersection of MR and MC.

11. © 2007 Thomson South-Western The Long-Run Equilibrium Two Characteristics As in a monopoly, price exceeds marginal cost. Profit maximization requires marginal revenue to equal marginal cost. The downward-sloping demand curve makes marginal revenue less than price. As in a competitive market, price equals average total cost. Free entry and exit drive economic profit to zero.

12. © 2007 Thomson South-Western What if a firm has short run losses? Firms will exit the market Decreases the number of products offered. Increases demand faced by the remaining firms. Shifts the remaining firms’ demand curves to the right. Increases the remaining firms’ profits.

13. © 2007 Thomson South-Western Figure 1 Monopolistic Competitors in the Short Run Demand Quantity 0 Price Loss- minimizing quantity Average total cost (b) Firm Makes Losses MR Losses ATC MC

14. © 2007 Thomson South-Western Problem Set 5.7 Find a partner, put your desks together, and dominate the worksheet! Raise your hand for any questions

15. © 2007 Thomson South-Western Monopolistic versus Perfect Competition There is a noteworthy difference between monopolistic and perfect competition: Excess capacity The actual capacity (production) by a firm is less than what is optimum for the firm

16. © 2007 Thomson South-Western Monopolistic versus Perfect Competition Excess Capacity There is no excess capacity in perfect competition in the long run. There is excess capacity in monopolistic competition in the long run. In monopolistic competition, output is less than the efficient scale.

17. © 2007 Thomson South-Western Figure 3 Monopolistic versus Perfect Competition Quantity 0 Price Demand (a) Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) (b) Perfectly Competitive Firm MC ATC MC ATC MR Efficient scale P Quantity produced Quantity produced = Efficient scale Excess capacity

18. © 2007 Thomson South-Western Monopolistic Competition and the Welfare of Society There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.

19. © 2007 Thomson South-Western Deadweight Loss Quantity Price 0 Demand MR ATC MC Monopoly quantity P =ATC Market efficient quantity

20. © 2007 Thomson South-Western ADVERTISING When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product. The firm is trying to shift their demand curve to the right to make more short-run profits.