Monopolistic Competition Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10

Overview What you will learn in this lecture Three fundamental characteristics Short run equilibrium Long run equilibrium Excess capacity Non price competition

Motivation of Imperfect Competition Advertising is everywhere in the economy In perfect competition and monopoly firms do little, if any, advertising Why? Where, then, is all the advertising coming from? We must consider firms that are neither perfect competitors nor monopolists

The Concept of Imperfect Competition Refers to market structures between perfect competition and monopoly there is more than one seller, but too few to create a perfectly competitive market products may not be standardized no free entry and exit Types of imperfectly competitive markets Monopolistic competition Oligopoly

Monopolistic Competition Hybrid of perfect competition and monopoly Three fundamental characteristics Many buyers and sellers Sellers offer a differentiated product Sellers can easily enter or exit the market Examples

I. Many Buyers and Sellers Under monopolistic competition, an individual buyer is a price taker But an individual seller, in spite of having many competitors, decides what price to charge Assume that no interaction among firms in market Each firm only supplies a small part of the market, that none of them needs to worry that its actions will be noticed—and reacted to—by others

II. Sellers Offer a Differentiated Product Each seller produces a somewhat different product from the others Faces a downward-sloping demand curve In this sense is more like a monopolist than a perfect competitor When it raises its price a modest amount, quantity demanded will decline (but not all the way to zero)

II. Sellers Offer a Differentiated Product What makes a product differentiated? Quality of product Tastes – a subjective matter Whether their perception is accurate or not Difference in location Thus, whenever a firm faces a downward-sloping demand curve, we know buyers perceive its product as differentiated Firm chooses its price

III. Easy Entry and Exit This feature is shared by monopolistic competition and perfect competition Plays the same role in both Ensures firms earn zero economic profit in long-run However, no barrier stops any firm from copying the successful business of other firms

Monopolistic Competition in the Short-Run Individual monopolistic competitor behaves very much like a monopoly Key difference is the availability of substitutes When a monopolistic competitor raises its price, its customers have one additional option Can buy similar good from some other firm

Monopolistically competitive firm making positive economic profit $ MC P0 ATC Demand Q0 MR Quantity

Monopolistic Competition in the Long-Run Free entry condition Continue to occur, and demand curve will continue to shift leftward Till the time when each firm earns zero economic profit In real world, monopolistic competitors often earn economic profit or loss in the short-run But—given enough time—profits attract new entrants, and losses result in an industry shakeout, until firms are earning zero economic profit

Monopolistically competitive firm making positive economic profit: invites entry, firm demand shifts inward $ MC P0 ATC Demand Q0 MR Quantity

Monopolistically competitive firm making positive economic profit: entry continues until profits are zero $ MC P0 ATC P1 Demand Q1 Q0 Quantity MR

At equilibrium, P = ATC (zero profit) and MR = MC $ MC ATC P0 Q0 MR Quantity

Features of monopolistically competitive industries Economy is not efficient - excess capacity too little output produced to achieve minimum cost per unit costly to consumers equilibrium price is above minimum ATC More firms (varieties) than necessary for least cost production Benefits Consumers usually benefit from product differentiation May tempt you to leap to a conclusion Consumers are better off under perfect competition; however In order to get beneficial results of perfect competition, all firms must produce identical output

Non-price Competition Definition: Any action a firm takes to increase demand for its output—other than cutting its price Example: better service, product guarantees, free home delivery, more attractive packaging another reason why monopolistic competitors earn zero economic profit in long-run Costly Must pay for advertising, for product guarantees, for better staff training Shift each firm’s ATC curve upward