Principles of Microeconomics Chapter 16 Monopolistic Competition

Monopolistic Competition Monopolistically Competitive Markets: Have many buyers and sellers Sell similar but differentiated products Free entry and exit in the market Firms: Have some price control In short run: experience economic profits + act as monopoly In long run: zero economic profits + act as perfect competition

Writing to Learn Exercise Log onto Amazon.com Search for an ordinary consumer good (ie: soap, socks, tea ect.) How many sellers do you find? How many different varieties of the product can you find? Do the prices differ? How is this related to the concept of monopolistic competition?

Monopolistic Competition in Short Run Firms have a “monopoly” on their differentiated good Exert price control over their good Can incur positive economic profits in short run!

In the short run… Market outcome looks similar to monopoly Profit Max Point: MR = MC Price > MR = MC Determines quantity based on MR = MC Determines price based on demand If P > ATC POSITIVE ECONOMIC PROFITS Possible in Short Run

Firms in the long run operate at: Market outcome similar to perfectly competitive markets Reason: FREE ENTRY/EXIT Firms in the long run operate at: P > MC Due to firm facing a downward sloping demand curve P = ATC Due to free entry and exit into the market

Firms in the long run operate at: Market outcome similar to perfectly competitive markets Reason: FREE ENTRY/EXIT Firms in the long run operate at: P > MC Due to firm facing a downward sloping demand curve P = ATC Due to free entry and exit into the market

Firms in the long run operate at: Market outcome similar to perfectly competitive markets Reason: FREE ENTRY/EXIT Firms in the long run operate at: P > MC Due to firm facing a downward sloping demand curve P = ATC Due to free entry and exit into the market

Long Run when P > ATC Adjust until P = ATC in Long run If P > ATC: Short run positive profits Overtime: more firms enter to take advantage of profits Increase variety of goods as more firms enter Decrease in demand for each firm’s differentiated good Decrease in price for firms until P = ATC Zero Economic Profits In long run Adjust until P = ATC in Long run

Short Run when P > ATC Gina’s Soap Makers Market for Soap MC Price (Cost) Price MC S ATC D MR D Quantity Quantity

Short Run when P > ATC Gina’s Soap Makers Market for Soap MC Price (Cost) Price MC S P* ATC P* MR = MC D MR D Q* Quantity Quantity

Short Run when P > ATC Gina’s Soap Makers Market for Soap MC Price (Cost) Price MC S P* ATC PROFIT P* ATC D MR D Q* Quantity Quantity In the short run – Gina’s Soap Makers Inc. is making a profit! Other firms observe this

Short Run to Long Run when P > ATC Gina’s Soap Makers Market for Soap MC Price (Cost) Price MC S S.2 P* ATC PROFIT ATC D MR D Q* Quantity Quantity New firms enter overtime to take advantage of the positive economic profits. Supply curve shifts  increase in number of buyers

Long Run when P > ATC Gina’s Soap Makers Market for Soap MC Price (Cost) Price MC S S.2 ATC P* P* P** P** D MR D MR.2 D.2 Quantity Q** Q* Quantity Q* Q** As new firms enter  supply of soap in the market goes up But for each individual firm  demand goes down because buyers have more options! No change in costs  adjustment until P= ATC

Long Run when P > ATC Gina’s Soap Makers Market for Soap MC Price (Cost) Price MC S S.2 ATC P* P* P** P** D MR D MR.2 D.2 Quantity Q** Q* Quantity Q* Q** Price for soap in the market decreases Quantity of soap available increases Gina’s price for soap decreases Quantity of soap she sells also decreases

Long Run when P < ATC Adjust until P = ATC in Long run If P < ATC: Short run negative profits – Loss! Overtime: firms exit market to avoid losses Decrease variety of goods as more firms exit Increase in demand for each firm’s differentiated good Increase in price for firms that stay in market until P = ATC Zero Economic Profits In long run Adjust until P = ATC in Long run

Application Consider John’s Muffin Shop which is currently competing with many other bakeries selling similar pastries in a small town, but none as good as John’s (so he believes). Assume that because of the market dynamics, John finds himself selling his muffins at a price below the cost to produce each muffin. Draw John’s Muffin Shop’s production decision graph as well as the market for pastries graph Indicate what is happening in the short run for John’s Muffin Shop in terms of price, quantity, average total cost, and profit/loss. What will happen in the long run for John’s Muffin Shop and the market for pastries? Illustrate to the best of your abilities.

Application Reflection Why does this matter? In the short run, monopolistically competitive firms can experience positive or negative economic profits depending on price and cost per unit (ATC). Due to free entry/exit in this type of market – all firms will return to long run equilibrium with zero economic profits. The number of firms in the market will continue to adjust until all firms are operating at this equilibrium and no single firm has the incentive to enter or leave the market. What’s the most important takeaway? Firms can tolerate negative economic profits temporarily, but eventually either they leave or, when other firms leave, the price adjusts so they operate with zero economic profits Remember, economic profits include implicit/opportunity costs! So zero economic profits does not mean zero accounting profits! MUDDIEST POINT?

Externalities in M. C. Market Positive for the consumer Negative for the business Product Variability Externality Business Stealing Externality Consumers are better off with more choices! So when new firms enter a market – consumers benefit because there are more varieties of the product to choose from Existing firms suffer when new firms enter a market More variety means less demand for the existing products New firms steal business, demand and consumers for the goods of existing firms

Externalities in M. C. Market Positive for the consumer Negative for the business Product Variability Externality Business Stealing Externality Consumers are better off with more choices! So when new firms enter a market – consumers benefit because there are more varieties of the product to choose from Existing firms suffer when new firms enter a market More variety means less demand for the existing products New firms steal business, demand and consumers for the goods of existing firms

Externalities in M. C. Market Positive for the consumer Negative for the business Product Variability Externality Business Stealing Externality Consumers are better off with more choices! So when new firms enter a market – consumers benefit because there are more varieties of the product to choose from Existing firms suffer when new firms enter a market More variety means less demand for the existing products New firms steal business, demand and consumers for the goods of existing firms

Key Takeaways Monopolistically Competitive firms act as both monopolies (in SR) and perfectly competitive firms (in LR) Have some excess capacity and mark up because have some price control Advertising only works when there are similar but differentiated products – only in M.C. markets