0. Monopolistic Competition16
Monopolistic Competition
N. Gregory Mankiw
Examples of monopolistic competition are everywhere: the clothes students wear, the frappaccinos they slurp up on their way to class, the magazines they read, the nightclubs where they dance.
As a result, students find the theory of monopolistic competition more relevant than the theory of perfect competition, which best describes products like wheat and soybeans, products that few students ever consider buying.
The last part of the chapter, on advertising and brand names, is especially interesting & useful for business students.
If students are reasonably comfortable with the material on perfect competition and monopoly, then this chapter should not be difficult. It is also shorter than average.
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1. In this chapter, look for the answers to these questions:
What market structures lie between perfect competition and monopoly, and what are their characteristics?
How do monopolistically competitive firms choose price and quantity? Do they earn economic profit?
In what ways does monopolistic competition affect society’s welfare?
What are the social costs and benefits of advertising? 1

2. Introduction: Between Monopoly and Competition
Two extremes
Perfect competition: many firms, identical products
Monopoly: one firm
In between these extremes: imperfect competition
Oligopoly: only a few sellers offer similar or identical products.
Monopolistic competition: many firms sell similar but not identical products.
In the preceding two chapters, we studied the two extremes of the competition spectrum. This chapter focuses on monopolistic competition, one of the market structures in between the two extremes.
Examples of each market type:
Perfect competition: wheat, milk
Monopoly: tap water, cable TV
Oligopoly: tennis balls, cigarettes
Monopolistic competition: novels, movies
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3. Characteristics & Examples of Monopolistic Competition
Characteristics:
Many sellers
Product differentiation
Free entry and exit
Examples:
apartments
books
bottled water
clothing
fast food
night clubs
Another important dimension of product differentiation, not emphasized in the book, is location. Gasoline seems like an undifferentiated product, yet different gas stations charge different prices. How can some gas stations get away with charging 5 or even 10 cents more per gallon? The answer is product differentiation by location.
Imagine you’re driving home in rush-hour traffic from a grueling 10-hour day at the office. The orange warning light comes on, indicating your car needs gas. After uttering a few choice expletives, you notice two gas stations at an upcoming intersection. The one on the right charges 5 cents more than the one on the left, but is easily accessible. The one on the left would require you to make a left-hand turn in heavy traffic to get into the station, and another to get out. And how much would you save? If you buy 20 gallons, you’d save only $1.
Alternatively, imagine you run a gas station located in a highly residential area, in which there are few other businesses – including gas stations. If people want gas, they can buy it from you, or they can drive 10 minutes to a more commercial area with lots of gas stations. Your location allows you to charge a higher price.
Business people have long understood that location is a critical dimension of product differentiation. Hence the saying “location, location, location.”
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4. Comparing Perfect & Monop. Competition
Perfect competition
Monopolistic competition
many
number of sellers
yes
free entry/exit
zero
long-run econ. profits
differentiated
identical
the products firms sell
That long-run profits are zero follows from free entry/exit.
The market power of a monopolistic competitor follows from the fact that it sells a product that is at least somewhat different from products sold by other firms.
The D curve facing a monopolistically competitive firm is downward-sloping because the firm has a bit of market power and sells a unique variety.
yes
none, price-taker
firm has market power?
downward-sloping
horizontal
D curve facing firm
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5. Comparing Monopoly & Monop. Competition
Monopoly
Monopolistic competition
many
one
number of sellers
yes no
free entry/exit
zero
positive
long-run econ. profits
yes
firm has market power?
For monopolistic competition, free entry/exit drives profits to zero in the long run.
In contrast, barriers to entry prevent the monopolist’s profits from being driven to zero.
A monopoly is the sole seller of a product with no close substitutes. In contrast, the monopolistic competitor sells a product with many close substitutes. As a result, demand for the monopolist’s product is less elastic than demand for the monopolistic competitor’s product.
downward-sloping
downward-sloping (market demand)
D curve facing firm
many
none
close substitutes
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6. A Monopolistically Competitive Firm Earning Profits in the Short Run
The firm faces a downward-sloping D curve.
At each Q, MR < P.
To maximize profit, firm produces Q where MR = MC.
The firm uses the D curve to set P. MC
ATC
Quantity
Price
profit D P MR
ATC
The graphical analysis of the monopolistically competitive firm’s output, price, and profits/losses is very similar to that of the monopoly firm.
One subtle difference is that the demand curve (and MR curve) facing the monopolistically competitive firm is likely to be flatter than the demand curve facing the monopolist, as the monopolistic competitor faces competition from other firms selling similar products. Q
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7. A Monopolistically Competitive Firm With Losses in the Short Run
For this firm, P < ATC at the output where MR = MC.
The best this firm can do is to minimize its losses. MC
ATC
Quantity
Price
losses
ATC D P MR Q
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8. Monopolistic Competition and Monopoly
Short run: Under monopolistic competition, firm behavior is very similar to monopoly.
Long run: In monopolistic competition, entry and exit drive economic profit to zero.
If profits in the short run: New firms enter market, taking some demand away from existing firms, prices and profits fall.
If losses in the short run: Some firms exit the market, remaining firms enjoy higher demand and prices.
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9. A Monopolistic Competitor in the Long Run
Entry and exit occurs until P = ATC and profit = zero.
Notice that the firm charges a markup of price over marginal cost and does not produce at minimum ATC. MC
ATC
Quantity
Price
P = ATC
markup
The level of output that minimizes ATC is greater than the output that maximizes the monopolistic competitor’s profits. Hence, we say the monopolistic competitor operates with excess capacity. (More on this topic on the next slide.) D MC MR Q
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10. Why Monopolistic Competition Is Less Efficient than Perfect Competition
1. Excess capacity
The monopolistic competitor operates on the downward-sloping part of its ATC curve, produces less than the cost-minimizing output.
Under perfect competition, firms produce the quantity that minimizes ATC.
2. Markup over marginal cost
Under monopolistic competition, P > MC.
Under perfect competition, P = MC.
Due to the markup of price over marginal cost, the market output under monopolistic competition will be smaller than the socially efficient output, as we discuss on the following slide.
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11. Monopolistic Competition and Welfare
Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets.
Because P > MC, the market quantity is below the socially efficient quantity.
Yet, not easy for policymakers to fix this problem: Firms earn zero profits, so cannot require them to reduce prices.
The problem facing policymakers here is similar to the problem arising from natural monopoly:
With natural monopoly, ATC is always falling, so MC is below ATC. If regulators force a natural monopoly to price at marginal cost, it will incur losses.
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12. Monopolistic Competition and Welfare
Number of firms in the market may not be optimal, due to external effects from the entry of new firms:
The product-variety externality: surplus consumers get from the introduction of new products
The business-stealing externality: losses incurred by existing firms when new firms enter market
The inefficiencies of monopolistic competition are subtle and hard to measure. No easy way for policymakers to improve the market outcome.
One of these externalities is positive, the other is negative. It’s not clear which one is bigger, and it may in fact differ by industry.
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13. A C T I V E L E A R N I N G 1 Advertising
1. So far, we have studied three market structures: perfect competition, monopoly, and monopolistic competition. In each of these, would you expect to see firms spending money to advertise their products? Why or why not?
2. Is advertising good or bad from society’s viewpoint? Try to think of at least one “pro” and “con.”
Consider breaking up your lecture with a 10 minute discussion. First, give your students a few quiet moments to formulate their responses. Then, ask for volunteers to share their answers. If you have a chalkboard or dry-erase board, concisely paraphrase each student’s response as it is volunteered. If a student volunteers a “wrong” answer, write it down anyway. After the class has generated a list, have the class go over each item on the list to make sure it really belongs on the list.
Benefits:
1) Breaks up the lecture into chunks.
2) Engages students.
3) Gets students to think about the implications of the market structures they’ve studied so far. (Hopefully, some will recognize that product differentiation is a critical determinant of firms’ motivation to spend on advertising.)
4) Makes students feel invested in learning the second half of the chapter. 13

14. Advertising
In monopolistically competitive industries, product differentiation and markup pricing lead naturally to the use of advertising.
In general, the more differentiated the products, the more advertising firms buy.
Economists disagree about the social value of advertising.
This section of the textbook has a nice FYI box contrasting the views on advertising of John Kenneth Galbraith and Frederic Hayek, two of the great economists of the 20th century.
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15. The Critique of Advertising
Critics of advertising believe:
Society is wasting the resources it devotes to advertising.
Firms advertise to manipulate people’s tastes.
Advertising impedes competition – it creates the perception that products are more differentiated than they really are, allowing higher markups.
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16. The Defense of Advertising
Defenders of advertising believe:
It provides useful information to buyers.
Informed buyers can more easily find and exploit price differences.
Thus, advertising promotes competition and reduces market power.
Results of a prominent study: Eyeglasses were more expensive in states that prohibited advertising by eyeglass makers than in states that did not restrict such advertising.
The study mentioned here was by economist Lee Benham, published in the Journal of Law and Economics in The textbook has a case study that discusses this research in more detail.
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17. Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts on advertising may signal the quality of its product to consumers, regardless of the content of ads.
Ads may convince buyers to try a product once, but the product must be of high quality for people to become repeat buyers.
The most expensive ads are not worthwhile unless they lead to repeat buyers.
When consumers see expensive ads, they think the product must be good if the company is willing to spend so much on advertising.
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18. Brand Names
In many markets, brand name products coexist with generic ones.
Firms with brand names usually spend more on advertising, charge higher prices for the products.
As with advertising, there is disagreement about the economics of brand names…
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19. The Critique of Brand Names
Critics of brand names believe:
Brand names cause consumers to perceive differences that do not really exist.
Consumers’ willingness to pay more for brand names is irrational, fostered by advertising.
Eliminating govt protection of trademarks would reduce influence of brand names, result in lower prices.
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20. The Defense of Brand Names
Defenders of brand names believe:
Brand names provide information about quality to consumers.
Companies with brand names have incentive to maintain quality, to protect the reputation of their brand names.
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21. CONCLUSION
Differentiated products are everywhere; examples of monopolistic competition abound.
The theory of monopolistic competition describes many markets in the economy, yet offers little guidance to policymakers looking to improve the market’s allocation of resources.
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22. CHAPTER SUMMARY
A monopolistically competitive market has many firms, differentiated products, and free entry.
Each firm in a monopolistically competitive market has excess capacity – produces less than the quantity that minimizes ATC. Each firm charges a price above marginal cost. 22

23. CHAPTER SUMMARY
Monopolistic competition does not have all of the desirable welfare properties of perfect competition. There is a deadweight loss caused by the markup of price over marginal cost. Also, the number of firms (and thus varieties) can be too large or too small. There is no clear way for policymakers to improve the market outcome. 23

24. CHAPTER SUMMARY
Product differentiation and markup pricing lead to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to reduce competition and take advantage of consumer irrationality. Defenders argue that firms use them to inform consumers and to compete more vigorously on price and product quality. 24