Monopolistic Competition Part II Econ 201 Lecture 8.1a May 26, 2009 Monopolistic Competition Part II

Characteristics of Monopolistic Competition Similar to Perfect Competition There are many producers in a given market. There are few barriers to entry and exit No extensive economies of scale No dominant firm or firms Differs from Perfect Competition goods and services are heterogeneous Consumers have clearly defined preferences and sellers attempt to differentiate their products from those of their competitors means that producers have some degree of control over price

Overview Monopolistic Competition Market Demand is downward sloping Result of product differentiation So is firm demand, but it is smaller and more elastic than Market Demand Firm sets price like a monopolist, but with less market power (more elastic) Faces competition (cross-price elasticity) Sets Price on the D curve where MR = MC

Overview Monopolistic Competitive firm Prices like a monopolist Chooses Qs @ MR = MC Price > MC However Price for MC will be less than Monopolist Closer to PC than M Qty Supplied for Monop Compet Industry > Monopoly

Overview Monopolistic Competition Also resembles Perfect Competition No economies of scale + free/ entry & exit Market characterized by a many firms Will drive long term economic profits to 0 Competitors produce “close” substitutes Even with product differentiation – firms have only limited market (pricing) power (similar to “competitive fringe”) Differs from Perfect Competition Is not as efficient Does not operate at min of LRAC Allocatively inefficient (MV > MC) “Excess Capacity” (too many firms/too much capital) Does produce greater product variety

MC in the Short-Run Qs set where MR = MC Earns + economic profit (monopoly rent)

MC in the Long-run SR economic profits -> promote entry by new firms Price will be “competed” down to LRAC So no economic profit in LR Firms will still not operate at min LRAC (unlike PC mkt) More entry (unstable equilibria) & DWLoss

Characteristics of MC Markets Departures from perfect competition Differences in cost Don’t operate at min of LRAC Each firm may operate at different SRAC Unstable equilibrium Short-run (+) economic profits -> induce entry (minimal barriers) -> compete profits away As newer, efficient firms enter -> older, less efficient exit -> “constructive” destruction (high rate of “turnover” like PC) In the long-run, Factors that differentiate products are duplicated by competing firms. drives price down and, monopolistically competitive firm will make zero economic profit (i.e. a rate of return equal to the rate required to compensate debt and equity holders for the risk of investing in the firm). Unlike in perfect competition, the monopolistically competitive firm does not produce at the lowest attainable average total cost.

Examples of MC Markets restaurants, cereal, clothing, shoes and service industries in large cities

Role of Advertising Basic Taxonomy of Advertising From an economist’s perspective 1) Informational Product quality, pricing, availability “good gas at a good price” 2) Persuasive Attempts to alter tastes and preferences with subjective information No product or pricing info

Advertising Critics of monopolistic competition fosters advertising and the creation of brand names. advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. Refuted by defenders of advertising (1) brand names can represent a guarantee of quality, and (2) advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands.

Should We Regulate MC Markets? Monopolistically competitive firms are inefficient, however: usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits; the government would have to regulate all firms that sold heterogeneous products Consumers value variety, i.e., product differentiation