Monopolistic Competiton

Assumptions Many sellers and many buyers Slightly different products Easy entry and exit (low barriers)

Effect of assumptions With many sellers, each firm has no effect on the others. If one firm changes its price the others will not notice or react. If a firm raises its price but the others do not, it will lose many its customers. Not all customers will switch to another firm because they like this seller’s product more than others.

Comparison to monopoly When a monopolist raises its price most consumers continue to buy the product because there are no close substitutes.

Comparison to perfect competition When a perfectly competitive firm raises its price, all of its current customers switch to other firms because the products are identical. They can get exactly the same thing from another firm at the market price.

MC firm’s demand When a mc firm raises its price, the other firms do not react by raising their prices. While its customers like their product better, other firms offer a very similar product at a lower price. Many will switch. Result: a small percentage increase in price will cause a large percentage decrease in quantity demanded = elastic demand.

MC firm’s demand When a mc firm lowers its price, the other firms do not react by lower their prices. Some customers of the other firms will switch to its product. While the number of customers that switch is small relative to the market, it is a big change for one firm. Result: a small percentage decrease in price will cause a large percentage increase in quantity demanded = elastic demand.

MC firm’s D and MR

Profit maximization

Deadweight loss

Long run For long run equilibrium, there is no incentive for firms to enter or exit. This occurs when each firm’s economic profit = 0, or accounting profit = normal profit. This means that the each firm’s price just covers their cost of production, including a normal profit as one of the costs.

Long run equilibrium

Reaching LR equilibrium If a typical firm’s demand curve is above LRAC then its profits will be greater than zero, causing other firms to enter. With more firms in the market the demand for each firm’s product will decrease. This will continue until profits equal zero and entry stops. What if its demand is below LRAC?

LR: PC vs MC In the LR each firm in PC will be at the bottom of its LRAC curve. Each firm in MC will be on the left side of its LRAC curve.

PC (left) vs MC (right)

PC vs MC In PC, each firm can sell as much as it wants at the market price. In MC, having a slightly different product allows each firm to raise its price, but it also limits the demand for its product. The result is that each firm in MC is slightly smaller than each firm in PC, resulting in slightly higher cost per unit.

Effect on consumers In PC, consumers get the lowest possible price, but no product variety. Each firm produces exactly the same thing. In MC, consumers pay slightly higher prices (because cost of production is slightly higher) but they can choose the one that they like the best.