Monopolistic Competition

Lecture 12 In this chapter, look for the answers to these questions:

How is monopolistic competition similar to perfect
competition? How is it similar to monopoly?
How do monopolistically competitive firms choose price
and quantity? Do they earn economic profit?
Monopolistic Competition In what ways does monopolistic competition affect
societys welfare?
What are the social costs and benefits of advertising?
Monopolistic competition:
a market structure in which many firms sell products that
are similar but not identical.
Examples: apartments, books, bottled water, clothing, fast
food

Comparing Perfect & Monop. Competition Comparing Monopoly & Monop. Competition

perfect monopolistic monopolistic

monopoly
competition competition competition
number of sellers one many
number of sellers many many
free entry/exit no yes
free entry/exit yes yes

long-run econ. profits zero zero long-run econ. profits positive zero

the products firms sell identical differentiated firm has market power? yes yes

firm has market power? none, price-taker yes downward-

downward-
D curve facing firm sloping
downward- sloping
D curve facing firm horizontal (market demand)
sloping
close substitutes none many
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Comparing Oligopoly & Monop. Competition A Monopolistically Competitive Firm

Earning Profits in the Short Run
monopolistic
oligopoly
competition The firm faces a
downward-sloping
number of sellers few many Price
D curve.
profit MC
importance of strategic At each Q, MR < P.
high low P ATC
interactions between firms
To maximize profit,
likelihood of fierce ATC
low high firm produces Q D
competition
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

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 A Monopolistically Competitive Firm
Monopolistic Competition in the Short
With Losses in the Short Run
Run
For this firm,
Short-run economic profits encourage new firms
P < ATC
to enter the market. This: at the output where
Price
MC
Increases the number of products offered. MR = MC.
losses ATC
The best this firm
Reduces demand faced by firms already in the can do is to
ATC
market. minimize its losses. P

Incumbent firms demand curves shift to the left. D

MR
Demand for the incumbent firms products fall, Q Quantity
and their profits decline.
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Monopolistic Competition and Monopoly

Monopolistic Competition in the Short
Run
Short-run economic losses encourage firms to
exit the market. This:
Decreases the number of products offered.
Increases demand faced by the remaining firms.
Shifts the remaining firms demand curves to the
right.
Increases the remaining firms profits.
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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A Monopolistic Competitor in the Long Run Excess Capacity

There is no excess capacity in perfect competition in the long run.
Entry and exit Free entry results in competitive firms producing at the point where
average total cost is minimized, which is the efficient scale of the
occurs until firm. i.e. ATC=MC
P = ATC and Price There is excess capacity in monopolistic competition in the long
profit = zero. MC run, output is less than the efficient scale of perfect competition.
ATC The monopolistic competitor operates on the downward-sloping
Notice that the part of its ATC curve, produces less than the cost-minimizing
firm charges a P = ATC output. i.e., monopolistically competitive firm could inc. quantity it produces and lower
ave. total cost; but doesnt do it bec. not profitable
markup of price markup Markup Over Marginal Cost
over marginal For a competitive firm, price equals marginal cost.
D
cost, and does MC For a monopolistically competitive firm, price exceeds marginal
MR
not produce at cost.
minimum ATC. Q Quantity Because price exceeds marginal cost, an extra unit sold at the
Mainly because MR < P; this is so posted price means more profit for the monopolistically competitive
because of price effect of downward firm.
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sloping demand curve
NOTE!

Considerable monopoly power (i.e. large markup) DOES NOT

NECESSARILY IMPLY HIGH PROFITS. Profits depend on
AVERAGE cost relative to price. Firm A might have more monopoly
power than firm B but earn a lower profit because of higher ATC
(p.363 of Pindyck and Rubenfield)

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 Excess Capacity... Markup Over Marginal Cost...

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price Price Price

MC MC Markup MC MC
ATC ATC ATC ATC

P
P = MC P = MR P = MC P = MR
Excess capacity (demand (demand
curve) Marginal curve)
cost
Demand MR Demand

Quantity Quantity Quantity Quantity

Quantity Efficient Quantity= Efficient Quantity Quantity
produced scale produced scale produced produced
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Monopolistic Competition and Welfare

Monopolistic versus Perfect Competition... Monopolistically competitive markets do not have all the desirable
welfare properties of perfectly competitive markets.
There is the normal deadweight loss of monopoly pricing in
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm monopolistic competition caused by the markup of price over marginal
cost.
Price Price
Because P > MC, the market quantity is below the socially efficient
MC MC
Markup ATC quantity.
ATC
Yet, not easy for policymakers to fix this problem: Firms earn zero
profits, so cannot require them to reduce prices.
P = MC P = MR Number of firms in the market may not be optimal, due to external
Marginal (demand effects from the entry of new firms:
cost curve)
the product-variety externality: surplus consumers get from the
Demand introduction of new products
MR
the business-stealing externality: losses incurred by existing firms
when new firms enter market
Quantity Efficient Quantity Quantity produced = Quantity
produced scale Efficient scale The inefficiencies of monopolistic competition are subtle and hard to
measure. No easy way for policymakers to improve the market
Excess capacity outcome.
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IMPORTANT POINT: DEADWEIGHT LOSS IS CREATED DUE TO

P-MC (the markup, esp in Monopolistic Competition) is pointless as clearly no value
goes to the consumer but also no value to Monopolistic Competition bec. 0 profits

Advertising The Defense of Advertising

In monopolistically competitive industries, product Defenders of advertising believe:
differentiation and markup pricing lead naturally to the It provides useful information to buyers.
use of advertising. Informed buyers can more easily find and exploit price
differences.
In general, the more differentiated the products, the Thus, advertising promotes competition and reduces market
more advertising firms buy. power.

Economists disagree about the social value of Advertising as a Signal of Quality

advertising. A firms willingness to spend huge amounts on advertising may signal
the quality of its product to consumers, regardless of the content of
The Critique of Advertising ads.
Ads may convince buyers to try a product once, but the product
Critics of advertising believe: must be of high quality for people to become repeat buyers.
Society is wasting the resources it devotes to advertising. The most expensive ads are not worthwhile unless they lead to
repeat buyers.
Firms advertise to manipulate peoples tastes.
When consumers see expensive ads, they think the product must
Advertising impedes competition it creates the perception be good if the company is willing to spend so much on
that products are more differentiated than they really are, advertising.
allowing higher markups.
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 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
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 government protection of trademarks would reduce
influence of brand names, result in lower prices.
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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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.
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.
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.
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