MONOPOLISTIC COMPETITION The monopolistically competitive firm in the short run, The long-run equilibrium, Monopolistic VS Perfect Competition, Monopolistic competition and the welfare of society. 1

2 Monopolistic competition : a market structure in which many firms sell products that are similar but not identical. Describes a market with the following attributes: Many sellers Product differentation Free entry Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of competition and monopoly, but oligopoly and monopolistic competition are different.

Oligopoly: there are only few sellers in the market and the small number of sellers makes rigorous competition less likely, and it makes strategic interaction among them. Monopolistic competition: there are many sellers, each of which is small compared to the market. These market structure depart from the perfectly competitive ideal, because each of the sellers offers a somewhat different product. 3 Differences between Monopolistic competition and Oligopoly

T HE MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT RUN. The products of the monopolistically competitive firms are different from those offered by other firms, and it faces a downward-sloping demand curve. Thus, the monopolistically competitive firm follows a monopolist’s rule for profit maximization: it choose the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find price consistent with that quantity. 4

5 In panel (a), price execeeds average cost, so the firm makes profit In panel (b), price is below average total cost, so the firm is unable to make a positive profit, but the best thing that the firm can do is to minimize its losses

T HE LONG - RUN EQUILIBRIUM When the firms are making profits, new firms have and incentive to enter the market, this entry increases the number of products from which customers can choose, and this entry shifts the demand curves faced by the incumbet firms to the left. As the demand for incumebent firms’ products falls, these firms experience declining profit. When firms are making losses, firms in the market have an incentive to exit. As firms exit, customers have fewer products from which to choose, and this exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms’ products rises, these firms experience rising profit (is the declining losses) 6

7 PROFIT PER UNIT SOLD = Price – Average total cost The maximum profit is zero only if these two curves touch each other without crossing.

M ONOPOLISTIC VS PERFECT COMPETITION 8 Two differences are notable: The perfectly competitive firm produces at the efficient scale (the quantity that minimizes average total cost), by contrast, the monopolistically competitive firm produces at less than the efficient scale.( EXCESS CAPACITY) Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition (MARKUP OVER MARGINAL COST)

M ONOPOLISTIC COMPETITION AND THE WELFARE OF SOCIETY Monopolistic competition does not agree with all the positive characteristics of perfect competition. In addition to the normal loss of monopoly pricing, because of the markup of price over marginal cost, the number of firms may not be optimal. In fact, when a firm considers entering the market with a new product, it considers only the profit it would make, but this entry has two external effects: The externality of the variety of the product : Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers. 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. Firms in perfect competition, producing goods substitutable to each other and putting a price equal to marginal cost, do not have any of these externalities. The possibility that the legislature corrects these inefficiencies is extremely limited since the inefficiencies are complex and difficult to measure. 9