Chapter 11

Monopolistic
Competition
and Product
Differentiation
 Assumptions of the Monopolistic
Competition Model

• Free entry and exit in the long run

 No barriers to entry
• Many firms, each one small relative to the
size of the market
 Firms will have limited market power.
• Each firm produces a differentiated product
 Consumers view the goods as close substitutes,
but not perfect substitutes.

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 Short-Run Profit Maximization for the
Monopolistic Competitor

• Product differentiation creates a small amount

of market power due to customer loyalty.
 Even if the firm raises its price, it will still retain
some of its customers.

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 Economic Efficiency

• Is a monopolistic competitive industry

 Allocatively efficient?
 Productively efficient?
 Technologically efficient?

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 Figure 11.3 Short-Run Profits

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 Loss Minimization
and the Shut-Down Point

• If demand decreases or costs increase,

profits will fall.
 If the demand curve just touches the ATC curve
at the profit-maximizing level of output, the firm
will earn normal economic profits.
 If the demand curve just touches the AVC curve
at the profit-maximizing level of output, the
firm will be indifferent between operating and
shutting down.

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 Figure 11.4 Minimizing Losses and
Reaching the Shutdown Point

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 Monopolistic Competition in the Long Run

• In the short run, monopolistically competitive

firms behave much like a monopolist.
• In the long run, however, monopolistic
competition differs from monopoly because
of free entry into the market.

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 Firm Entry in Monopolistic Competition

• If firms in a monopolistically competitive

market are earning positive economic profits,
then new firms will enter the market.
 Similar to perfect competition

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 Figure 11.5 Effects of New Entrants on the
Demand for Cheesesteaks at John’s Roast Pork

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 Firm Entry in Monopolistic Competition

• An important difference between monopolistic

competition and perfect competition is that
price does not fall to the minimum point on
the long-run average cost curve.
 The firms are not efficient.

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 Summary of Monopolistic Competition

• Each firm maximizes profits by producing the

output for which MR = MC.
 Price is determined by the demand curve.
• Long-run entry implies that firms will be driven
towards zero economic profits in the long run.
 P = LAC
• Price will be greater than the minimum point
of LAC.
• Firms have different demand and costs,
leading to long-run turnover of firms.
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 Allocative Efficiency

• For monopolistically competitive firms,

the profit-maximizing level of output is
less than that which minimizes LAC.
 Monopolistically competitive firms are not
as efficient as perfectly competitive firms.

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 Figure 11.6 The Long-Run Monopolistic
Competition Equilibrium Versus the
Perfect Competition Equilibrium

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 Excess Capacity

• As a result of underproduction at
both the firm and industry level,
monopolistically competitive firms are
said to exhibit excess capacity.
 Output could be increased without any
firms earning losses.

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 The Benefits of Variety

• Is the reduction in efficiency associated

with monopolistic competition bad
for society?
• Not necessarily:
 Because consumers value variety, the
benefits of product differentiation may
offset the costs of excess capacity.

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 Table 11.1 Summary of Market Structure
Characteristics for Perfect Competition,
Monopolistic Competition, and Monopoly

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 Advertising: Information or Persuasion?

• Unlike perfectly competitive firms or

monopolists, monopolistically competitive
firms will advertise to inform customers about
their product.

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 Brand Identity and Brand Loyalty

• The goal of advertising is to create:

 Brand Identity—the consumer’s ability to
recognize a product and associate it with a
specific name.
 Brand Loyalty—a consumer’s willingness
to remain with a specific product despite
the existence of competing products.
• Makes demand less elastic

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 Types of Advertising

• Informational—increases consumers’
knowledge of important product
characteristics and price.
• Persuasive—attempts to alter consumer
tastes and preferences by using
subjective information.

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 Summary (cont’d)

• In the long run, because of free entry

and exit, monopolistically competitive
firms will earn zero economic profits.
• Monopolistically competitive firms
are less efficient than perfectly
competitive firms.
 Excess capacity
• Product differentiation offsets some of
the loss of efficiency.
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 Summary (cont’d)

• Firms use adverting to differentiate their

product from competing products.
 Informational
 Persuasive

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