1. Monopolistic Competition
Chapter 17
Monopolistic Competition 1

2. Objectives
1. Recognize imperfect competition among firms that sell differentiated products.
2. Understand the equalibrium characteristics of monopolistic competition.
3. Be able to evaluate the outcomes of monopolistically competitive market.
4. Understand the issues surrounding the effects of advertising.
5. Understand the debate over the role of brand names 1

3. The Spectrum of Market Structure
Pure
Competition
Chapter 14
Pure
Monopoly
Chapter 15
Imperfect
Competition
Chapters 16 & 17 2

4. Imperfect Competition
Two types of imperfectly competitive markets:
Monopolistic Competition
Many firms selling products that are similar but not identical (e.g. movies.)
Oligopoly
Only a few sellers, each offering a similar or identical product to the others (e.g. tennis balls.) 3

5. Monopolistic Competition
Markets that have some features of competition and some features of monopoly.
Attributes of Monopolistic Competition
Many Sellers
Product Differentiation
Free Entry/Exit 4

6. Monopolistic Competition
Monopolistic Competition is a market structure characterized by
Many sellers
Highly differentiated product
Some control over price (pricemaker)
Easy entrance and exit from the market

7. Attribute: Many Sellers
Many firms competing for the same group of customers.
Examples:
books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc. 5

8. Attribute: Product Differentiation
Alternative forms of differentiation:
quality differences; additional service; location; and packaging.
Toys or prizes with kid’s meals at fast-food restaurants.
Results in firm facing a downward-sloping demand curve.
Demand curve is highly, but not perfectly, elastic. 6

9. Attribute: 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. 7

10. Monopolistic Competition...
A market structure between perfectly competitive and monopolistic.
Departs from the perfectly competitive because each seller offers a somewhat different product.
Departs from a monopoly because there are many sellers, each of which is small compared to the market. 8

11. Short-Run Operation in Monopolistic Competition
In the short-run, the monopolistically competitive firm:
Follows a monopolist’s rule for profit-maximization.
MR = MC
Price > ATC
Price < ATC
Figure 17-1 9

12. Monopolistically Competitors in the Short-Run
Price MC
ATC P
ATC
Demand MR
Quantity
Q Profit Max. 10

13. Monopolistically Competitors in the Short-Run
Price MC
ATC P
P>ATC
Firm Makes Profit
ATC
Demand MR
Quantity
Q Profit Max. 11

14. Monopolistically Competitors in the Short-Run
Price MC
ATC
ATC P
Demand MR
Quantity
Q Loss Min. 12

15. Monopolistically Competitors in the Short-Run
Price MC
ATC
ATC P
P<ATC
Firm Makes Losses
Demand MR
Quantity
Q Loss Min. 13

16. Long-Run Operation in Monopolistic Competition
If firms are making economic profits in the short-run, new firms are encouraged to enter the market.
Results in the following:
Increases the number of products offered
Reduces demand faced by each firm
Demand curves shift to the left, leading to
More elastic demand. 14

17. Long-Run Operation in Monopolistic Competition
Firms will enter and exit until the firms are making exactly zero economic profits.
Two characteristics of monopolistic competition in the long-run:
Price exceeds marginal cost
Price equals average total cost
Figure 17-2 15

18. A Monopolistic Competitor in the Long-Run
Price MC
ATC
P=ATC D MR
Quantity
Q Profit Max. 16

19. Monopolistic Competition vs. Perfect Competition
Two differences arise in the long-run between monopolistic competition and perfect competition:
Excess Capacity
Markup 17

20. Monopolistic Competition: Excess Capacity
In perfect competition, firms produce at the efficient scale, i.e. the point where average total cost is minimized.
Free entry in competitive markets drive firms to produce at the minimum of average total cost.
Figure 17-3 18

21. The Competitive Firm’s Output in the Long-Run
Price MC
ATC
P=MC
P=MR=AR
Quantity
QEfficient Scale 19

22. Monopolistic Competition: Excess Capacity
In monopolistic competition, the quantity of output is less than the “efficient scale” of perfect competition.
A monopolistically competitive firm could increase the quantity it produces and lower the average total cost of production. 20

23. Monopolistically Competitive Output in the Long-Run
Price MC
ATC P MC
Demand MR
Quantity
QProduced 21

24. Monopolistically Efficient Output in the Long-Run
Price MC
ATC P MC
Demand MR
Quantity Q
Q Efficient Scale 22

25. Monopolistically Efficient Output in the Long-Run
Price MC
ATC P
Excess
Capacity MC
Demand MR
Quantity Q
Q Efficient Scale 23

26. Monopolistic Competition: Mark Up Over Marginal Cost
For a competitive firm, price equals marginal cost.
For a monopolistically competitive firm, price exceeds marginal cost.
Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistic competitive firm. 24

27. Monopolistically Competitive Output in the Long-Run
Price MC
ATC P
Mark-Up MC
Demand MR
Quantity Q
Q Efficient Scale 25

28. Monopolistic Competition and the Welfare of Society
Inefficiencies may arise and include:
The markup price over marginal cost
Some consumers who value the good at more than the marginal cost of production will be deterred from buying it.
Results in “deadweight loss” to society. 26

29. 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.
However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.

30. Monopolistic Competition and the Welfare of Society
Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.

31. Monopolistic Competition and the Welfare of Society
The number of firms in the market may not be the “ideal” one.
There may be too much or too little entry. May lead to “externalities” of entry.
Externalities of Entry:
Product-Variety externality
Business-Stealing externality 27

32. Monopolistic Competition and the Welfare of Society
The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.

33. Monopolistic Competition and the Welfare of Society
The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.

34. Quick Quiz! List the three key attributes of monopolistic competition.
Draw and explain a diagram to show the long-run equilibrium in a monopolistically competitive market. 28

35. Monopolistic Competition: Advertising and Brand Names
Product differentiation leads to advertising and brand names.
Some critics of monopolistic competition contend that advertising and brand name exploit consumers and reduce competition.
Defenders argue that advertising increases competition by offering a greater variety of products and prices. 29

36. Monopolistic Competition: Advertising
Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue for advertising.
As a whole (total economy) about 2 percent of total firm revenue, or over $100 billion a year is spent on advertising. 30

37. Advertising
Critics of advertising argue that firms advertise in order to manipulate people’s tastes.
They also argue that it impedes competition by implying that products are more different than they truly are.

38. Advertising
Defenders argue that advertising provides information to consumers
They also argue that advertising increases competition by offering a greater variety of products and prices.
The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.

39. Monopolistic Competition: Advertising and Brand Names
Brand Names may provide two benefits to consumers:
Provide consumers information about quality when quality cannot be easily judged in advance of purchase.
Give firms an incentive to maintain high quality. 31

40. Brand Names
Critics argue that brand names cause consumers to perceive differences that do not really exist.

41. Summary
Monopolistically competitive markets are characterized by many firms each producing a differentiated product with freedom of market entry.
In equilibrium, monopolistically competitive markets produce with some excess capacity and each firm charges a price above marginal cost. 32

42. Summary
The selling price of a monopolistic competitive market results in some deadweight losses and resource misallocation.
Product differentiation leads to advertising and brand names. 33

43. Summary
A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry.
The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.

44. Summary
Monopolistic competition does not have all of the desirable properties of perfect competition.
There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost.
The number of firms can be too large or too small.

45. Summary
The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names.
Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition.

46. Summary
Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.