Chapter 17

Monopolistic Competition

Objectives

1. Recognize imperfect competition amongfirms that sell differentiated products.

2. Understand the equalibrium characteristicsof monopolistic competition.

3. Be able to evaluate the outcomes of monopolistically competitive market.

4. Understand the issues surrounding theeffects of advertising.

5. Understand the debate over the roleof brand names

The Spectrum of Market Structure

PureCompetition

Chapter 14

PureMonopoly

Chapter 15

ImperfectCompetitionChapters 16 & 17

Imperfect Competition

Two types of imperfectly competitive markets:

Monopolistic CompetitionMany firms selling products that are similar but

not identical (e.g. movies.)

OligopolyOnly a few sellers, each offering a similar or

identical product to the others (e.g. tennis balls.)

Monopolistic Competition

Markets that have some features of competition and some features of monopoly.

Attributes of Monopolistic Competition Many Sellers Product Differentiation Free Entry/Exit

Monopolistic Competition

Monopolistic Competition is a market structure characterized by

1. Many sellers

2. Highly differentiated product

3. Some control over price (pricemaker)

4. Easy entrance and exit from the market

Attribute: Many Sellers

Many firms competing for the same group of customers.

Examples:– books, CDs, movies,

computer games, restaurants, piano lessons, cookies, furniture, etc.

Attribute: Product Differentiation

Alternative forms of differentiation:– quality differences; additional service;

location; and packaging.– Toys or prizes with kid’s meals at fast-food

restaurants.

Results in firm facing a downward-sloping demand curve.– Demand curve is highly, but not

perfectly, elastic.

Attribute: Free Entry or Exit

Firms can enter or exit the market

without restriction.

The number of firms in the market adjusts until

economic profits are zero.

Monopolistic Competition...

A market structure between perfectly competitive and monopolistic.

Departs from the perfectly competitive because each seller offers a somewhat different product.

Departs from a monopoly because there are many sellers, each of which is small compared to the market.

Short-Run Operation in Monopolistic Competition

In the short-run, the monopolistically competitive firm:– Follows a monopolist’s rule for profit-

maximization.MR = MCPrice > ATC Price < ATC

– Figure 17-1

Monopolistically Competitors in the Short-Run

Quantity

MCATC

Q Profit Max.

Price

MR

Demand

ATC

P

Monopolistically Competitors in the Short-Run

Quantity

MCATC

Q Profit Max.

Price

ATC

P

MR

Demand

P>ATC

Firm Makes Profit

Monopolistically Competitors in the Short-Run

Quantity

MCATC

Q Loss Min.

Price

P

ATC

MRDemand

Monopolistically Competitors in the Short-Run

Quantity

MCATC

Q Loss Min.

Price

P

ATC

MRDemand

P<ATCFirm Makes

Losses

Long-Run Operation in Monopolistic Competition

If firms are making economic profits in the short-run, new firms are encouraged to enter the market.

Results in the following:– Increases the number of products offered– Reduces demand faced by each firm– Demand curves shift to the left, leading to– More elastic demand.

Long-Run Operation in Monopolistic Competition

Firms will enter and exit until the firms are making exactly zero economic profits.

Two characteristics of monopolistic competition in the long-run:

–Price exceeds marginal cost

–Price equals average total cost– Figure 17-2

A Monopolistic Competitor in the Long-Run

Quantity

MC

ATC

Q Profit Max.

Price

P=ATC

D

MR

Monopolistic Competition vs.Perfect Competition

Two differences arise in the long-run between monopolistic competition and perfect competition:

–Excess Capacity

–Markup

Monopolistic Competition:Excess Capacity

In perfect competition, firms produce at the efficient scale, i.e. the point where average total cost is minimized.

Free entry in competitive markets drive firms to produce at the minimum of average total cost.

Figure 17-3

The Competitive Firm’s Output in the Long-Run

Quantity

MCATC

P=MR=AR

QEfficient Scale

Price

P=MC

Monopolistic Competition:Excess Capacity

In monopolistic competition, the quantity of output is less than the “efficient scale” of perfect competition.

A monopolistically competitive firm could increase the quantity it produces and lower the average total cost of production.

Monopolistically Competitive Output in the Long-Run

Quantity

MCATC

QProduced

Price

MC

P

MR

Demand

Monopolistically Efficient Output in the Long-Run

Quantity

MCATC

Q

Price

MC

P

MR

Demand

Q Efficient Scale

Monopolistically Efficient Output in the Long-Run

Quantity

MCATC

Q

Price

MC

P

MR

Demand

Q Efficient Scale

ExcessCapacity

Monopolistic Competition:Mark Up Over Marginal Cost

For a competitive firm, price equals marginal cost.

For a monopolistically competitive firm, price exceeds marginal cost.

Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistic competitive firm.

Monopolistically Competitive Output in the Long-Run

Quantity

MCATC

Q

Price

MC

P

MR

Demand

Q Efficient Scale

Mark-Up

Monopolistic Competition and the Welfare of Society

Inefficiencies may arise and include:The markup price over marginal cost

– Some consumers who value the good at more than the marginal cost of production will be deterred from buying it.

– Results in “deadweight loss” to society.

Monopolistic Competition and the Welfare of Society

There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.

However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.

Monopolistic Competition and the Welfare of Society

Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.

Monopolistic Competition and the Welfare of Society

The number of firms in the market may not be the “ideal” one.– There may be too much or too little entry.

May lead to “externalities” of entry.

– Externalities of Entry: Product-Variety externality Business-Stealing externality

Monopolistic Competition and the Welfare of Society

The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.

Monopolistic Competition and the Welfare of Society

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.

Quick Quiz!

List the three key attributes of monopolistic competition.

Draw and explain a diagram to show the long-run equilibrium in a monopolistically competitive market.

Monopolistic Competition: Advertising and Brand Names

Product differentiation leads to advertising and brand names.

Some critics of monopolistic competition contend that advertising and brand name exploit consumers and reduce competition.

Defenders argue that advertising increases competition by offering a greater variety of products and prices.

Monopolistic Competition: Advertising

Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue for advertising.

As a whole (total economy) about 2 percent of total firm revenue, or over $100 billion a year is spent on advertising.

Advertising Critics of advertising argue that firms

advertise in order to manipulate people’s tastes.

They also argue that it impedes competition by implying that products are more different than they truly are.

Advertising Defenders argue that advertising

provides information to consumers They also argue that advertising

increases competition by offering a greater variety of products and prices.

The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.

Monopolistic Competition: Advertising and Brand Names

Brand Names may provide two benefits to consumers:– Provide consumers information about quality

when quality cannot be easily judged in advance of purchase.

– Give firms an incentive to maintain high quality.

Brand Names Critics argue that brand names

cause consumers to perceive differences that do not really exist.

Summary Monopolistically competitive markets

are characterized by many firms each producing a differentiated product with freedom of market entry.

In equilibrium, monopolistically competitive markets produce with some excess capacity and each firm charges a price above marginal cost.

Summary The selling price of a monopolistic

competitive market results in some deadweight losses and resource misallocation.

Product differentiation leads to advertising and brand names.

Summary A monopolistically competitive

market is characterized by three attributes: many firms, differentiated products, and free entry.

The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.

Summary

Monopolistic competition does not have all of the desirable properties of perfect competition.

There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost.

The number of firms can be too large or too small.

Summary

The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names.

Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition.

Summary

Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.