Monopolistic Competition Chapter 17 Monopolistic Competition

Characteristics of Monopolistic Competition Many sellers Product differentiation Free entry Examples: books, CD’s, restaurants, movies, etc.

In the Short Run… Because the product is differentiated, it faces a downward D curve and MR curve Profit-Maximization is same as monopoly: go to MR=MC for Q of output, then to D curve to find P Firms will make profits or losses just like a monopoly in short run

Figure 1 Monopolistic Competition in the Short Run (a) Firm Makes Profit Price MC ATC Demand MR Profit- maximizing quantity Price Average total cost Profit Quantity

Figure 1 Monopolistic Competitors in the Short Run (b) Firm Makes Losses Price MC ATC Losses Loss- minimizing quantity Average total cost Demand Price MR Quantity

In the Long Run… Profits = entry; shifts D curve to left Losses = exit; shifts D curve to right This process continues until firms are making exactly 0 economic profit D curve and ATC curve become TANGENT P > MC P > MR P = ATC

Figure 2 A Monopolistic Competitor in the Long Run Price MC ATC Demand The demand curve is tangent to the ATC curve. MR Profit-maximizing quantity P = ATC And this tangency lies vertically above the intersection of MR and MC. Quantity

Monopolistic vs. Perfect Competition Excess Capacity – firms produce on the downward-sloping portion of ATC, not at efficient scale. Therefore, they could produce more and decrease costs. Markup – P > MC because firm always has some market power, so an extra unit sold = higher profit

Monopolistic Competition and the Welfare of Society Inefficiency comes from P > MC, so a mon. comp. market has same DWL as monopoly pricing There is no way to regulate firms # of firms in market is not “ideal” because of too much or too little entry

Externalities with entry/exit Product-variety externality – consumers get some consumer surplus from the intro of a new product, entry of a new firm is a positive externality to consumers Business-stealing externality – other firms lose customers and profits from entry, it is a negative externality on existing firms

Advertising Varies with products Firms selling highly differentiated goods spend about 10%-20% of revenue on advertising (soft drinks, razor blades, cereal, dog food…) Firms selling industrial goods spend very little on advertising (satellites, etc.) Firms selling homogeneous products spend nothing (wheat, peanuts, oil)

Critique of Advertising manipulative of people’s tastes Psychological vs. informational Impedes competition – convinces people products are more different than they really are

Defense of Advertising Information allows customers to make better decisions Fosters competition by allowing customers to take advantages of price differences Decreases market power Can signal to the consumer that the quality of product is high

Make sure to… Read case study about eyeglasses Read section on brand names and the pros and cons of them