2. C H A P T E R C H E C K L I S T
When you have completed your study of this chapter, you will be able to
Describe and identify monopolistic competition. 1
Explain how a firm in monopolistic competition determines its output and price in the short run and the long run . 2
Explain why advertising costs are high and wy firms use brand names in monopolistic competition. 3

3. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
Monopolistic competition is a market structure in which:
A large number of independent firms compete.
Each firm produces a differentiated product.
Firms compete on product quality, price, and marketing.
Firms are free to enter and exit.

4. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
Large Number of Firms
Like perfect competition, the market has a large number of firms. Three implications are:
Small market share
No market dominance
Collusion impossible

5. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
Product Differentation
Product differentiation
Making a product that is slightly different from the products of competing firms.
A differentiated product has close substitutes but it does not have perfect substitutes.
When the price of one firm’s product rises, the quantity demanded of that firm’s product decreases.

6. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
Competing on Quality, Price, and Marketing
Quality
Design, reliability, service, ease of access to the product.
Price
A downward sloping demand curve.
Marketing
Advertising and packaging

7. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
Entry and Exit
No barriers to entry.
A firm cannot make economic profit in the long run.

8. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
Identifying Monopolistic Competition
Two indexes:
The four-firm concentration ratio
The Herfindahl-Hirschman Index

9. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
The four-firm concentration ratio
The percentage of the value of sales accounted for by the four largest firms in the industry.
The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly.
A ratio that exceeds 40 percent: indication of oligopoly.
A ratio of less than 40 percent: indication of monopolistic competition.

10. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
The Herfindahl-Hirschman Index (HHI)
The square of the percentage market share of each firm summed over the largest 50 firms in a market.
Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent.
HHI = = 3,450
A market with an HHI less than 1,000 is regarded as competitive.
An HHI between 1,000 and 1,800 is moderately competitive.

11. 15.1 WHAT IS MONOPOLISTIC COMPETITION?
Limitations of Concentration Measures
The two main limitations of concentration measures alone as determinants of market structure are their failure to take proper account of
The geographical scope of a market
Barriers to entry and firm turnover

12. 15.2 OUTPUT AND PRICE DECISIONS
How, given its costs and the demand for its jeans, does Tommy Hilfiger decide the quantity of jeans to produce and the price at which to sell them?
The Firm’s Profit-Maximizing Decision
The firm in monopolistic competition makes its output and price decision just like a monopoly firm does.
Figure 15.1 on the next slide illustrates this decision.

13. 15.2 OUTPUT AND PRICE DECISIONS
1. Profit is maximized when MR = MC
2. The profit-maximizing output is 125 pairs of Tommy jeans per day.
3. The profit-maximizing price is $75 per pair.
ATC is $25 per pair, so
4. The firm makes an economic profit of $6,250 a day.

15. 15.2 OUTPUT AND PRICE DECISIONS
Profit Maximizing Might Be Loss Minimizing
Some firms in monopolistic competition have a tough time making a profit.
A burst of entry into an industry can limit the demand for each firm’s own product.
Figure 15.1 on the next slide illustrates a firm incurring a loss in the short run.

16. 15.2 OUTPUT AND PRICE DECISIONS
1. Loss minimized when MC = MR
2. The loss-minimizing output is 40,000 customers.
3. The price is $40 per month, which is less than ATC.
4. The firm incurs an economic loss.

18. 15.2 OUTPUT AND PRICE DECISIONS
Long Run: Zero Economic Profit
Economic profit induces entry and economic loss induces exit, as in perfect competition.
Entry decreases the demand for the product of each firm.
Exit increases the demand for the product of each firm.
In the long run, economic profit is competed away and firms earn normal profit.
Figure 15.3 on the next slide illustrates long-run equilibrium.

19. 15.2 OUTPUT AND PRICE DECISIONS
1. The output that maximizes profit is 75 pairs of Tommy jeans a day.
2. The price is $50 per pair. Average total cost is also $50 per pair.
3. Economic profit is zero.

21. 15.2 OUTPUT AND PRICE DECISIONS
Monopolistic Competition and Perfect Competition
The two key differences between monopolistic competition and perfect competition are that in monopolistic competition, there is
Excess capacity
A markup of price over marginal cost

22. 15.2 OUTPUT AND PRICE DECISIONS
Excess Capacity
A firm has excess capacity if the quantity it produces is less that the quantity at which average total cost is a minimum.
A firm’s efficient scale is the quantity of production at which average total cost is a minimum.
Markup
A firm’s markup is the amount by which price exceeds marginal cost.

23. 15.2 OUTPUT AND PRICE DECISIONS
1. The efficient scale is 100 pairs of jeans a day.
2. The quantity produced is less than the efficient scale and the firm has excess capacity.
3. Price exceeds marginal cost by the amount of the markup.

25. 15.2 OUTPUT AND PRICE DECISIONS
In perfect competition, the efficient quantity is produced and price equals marginal cost.

27. 15.2 OUTPUT AND PRICE DECISIONS
Is Monopolistic Competition Efficient
Efficiency requires marginal benefit to equal marginal cost.
In monopolistic competition, price exceeds marginal cost, which is an indicator of inefficiency.
Making the Relevant Comparison
Price exceeds marginal cost because of product differentiation. But product variety is valued.
The Bottom Line
The bottom line is ambiguous. But compared to the alternative, monopolistic competition looks efficient.

28. 15.3 DEVELOPMENT AND MARKETING
Innovation and Product Development
Wherever economic profits are earned, imitators emerge.
To maintain economic profit, a firm must seek out new products.
Cost Versus Benefit of Product Innovation
The firm must balance the cost and benefit at the margin.

29. 15.3 DEVELOPMENT AND MARKETING
Efficiency and Product Innovation
Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which equals the amount the consumer is willing to pay.
The marginal benefit to the producer is the marginal revenue, which in equilibrium equals marginal cost.
Because price exceeds marginal cost, product improvement is not pushed to its efficient level.

30. 15.3 DEVELOPMENT AND MARKETING
Advertising
Firms in monopolistic competition spend a large amount on advertising and packaging their products.
Marketing Expenditures
A large proportion of the prices that we pay cover the cost of selling a good.
Figure 15.5 on the next slide shows some estimates of marketing expenditures for some familiar markets.

31. 15.3 DEVELOPMENT AND MARKETING

33. 15.3 DEVELOPMENT AND MARKETING
Selling Costs and Total Costs
Advertising expenditures increase the costs of a monopolistically competitive firm above those of a perfectly competitive firm or a monopoly.
Advertising costs are fixed costs.
Advertising costs per unit decrease as production increases.
Figure 15.6 on the next slide illustrates the effects of selling costs on total cost.

34. 15.3 DEVELOPMENT AND MARKETING
1. When advertising costs are added to . . .
2. … the average total cost of production, …
3. … average total cost increases by a greater amount at small outputs than at large outputs.

36. 15.3 DEVELOPMENT AND MARKETING
4. If advertising enables sales to increase from 25 pairs of jeans a day to 100 pairs a day, it lowers the average total cost from $60 a pair to $40 a pair.

38. 15.3 DEVELOPMENT AND MARKETING
Selling Costs and Demand
Advertising and other selling efforts change the demand for a firm’s product.
The effects are complex:
A firm’s own advertising increases the demand for its product
Advertising by all firms might decrease the demand for any one firm’s product and make demand more elastic.
The price and markup might fall.

39. 15.3 DEVELOPMENT AND MARKETING
Figure 15.7 shows the possible effect of advertising.
With no advertising, demand is low but the markup is large.

41. 15.3 DEVELOPMENT AND MARKETING
With advertising, average total cost increases and the ATC curve becomes ATC1.
Demand decreases and becomes more elastic.
Profit maximizing output increases, the price falls, and the markup shrinks.

43. 15.3 DEVELOPMENT AND MARKETING
Using Advertising to Signal Quality
Some advertising is very costly and has almost no information content about the item being advertised.
Such advertising is used to signal high quality.
A signal is an action taken by an informed person or firm to send a message to uninformed people.
Signaling works because it is profitable to signal high quality and deliver it but unprofitable to signal a high quality product and not deliver it.

44. 15.3 DEVELOPMENT AND MARKETING
Brand Names
Brand names are also used to provide information about the quality of a product.
It is costly to establish a widely recognized brand name.
Like costly advertising, a brand name signals high quality.
Brand names work because it is unprofitable to incur the cost of creating a brand name and then deliver a low quality product.

45. 15.3 DEVELOPMENT AND MARKETING
Efficiency of Advertising and Brand Names
Advertising and brand names that provide information about the quality of products so that buyers are able to make better choices can be efficient if the marginal cost of the information equals its marginal benefit.
The final verdict on the efficiency of monopolistic competition is ambiguous.