Monopolistic Competition Books CD’s Movies Computer Games Restaurants Hockey lessons Cookies Furniture Monopolistic Competition lies between extremes: Perfect Competition and Monopoly. © 2000 Claudia Garcia - Szekely

Monopolistic Competition Can’t react to rival’s actions Can’t make agreements to set prices Act independently of rivals Many Firms Each firm faces its own downward sloping demand curve Set their own price Differentiated Products Free entry Long Run profits are zero Perfect Information Firms cannot charge higher prices than competitors © 2000 Claudia Garcia - Szekely

Like a Monopolist The firm faces a downward sloping demand curve Like a Perfectly Competitive firm It supplies only a portion (share) of the market demand Market Demand P Q Total Market Demand Fewer Substitutes for Hamburgers Steeper: Less Elastic: Fewer Substitutes Market Demand P Demand perceived by the firm Firm’s Demand Flatter: More elastic: More Substitutes for specific brand More Substitutes for Burger King Hamburgers Q Firm’s Share Total Total © 2000 Claudia Garcia - Szekely

Profit Maximizing Output Level MC Like in Perfect Competition and Monopoly : The firm chooses the Profit Maximizing Output level where MR = MC Pmc d Firm’s share of total Demand qmc MR © 2000 Claudia Garcia - Szekely © 2000 Claudia Garcia - Szekely

© 2000 Claudia Garcia - Szekely The Short Run MC Like in Perfect Competition and Monopoly if P > ATC firms enjoy profits ATC Pmc Profit d qmc MR © 2000 Claudia Garcia - Szekely © 2000 Claudia Garcia - Szekely

Profits Attract New Firms Existing firms’ market share shrinks The firm’s demand curve shifts left Existing firms increase advertising costs to defend market share The firm’s ATC curve shifts upwards © 2000 Claudia Garcia - Szekely © 2000 Claudia Garcia - Szekely

Market share (demand) and Costs shift until Profits disappear Long Run Like in Perfect Competition Profits attract new firms into the market MC1 MC0 ATC1 ATC0 The firm’s market share decrease and its ATC increase due to higher advertising costs Pmc Pmc Profit Market share (demand) and Costs shift until Profits disappear d d q1 q0 MR1 MR0 © 2000 Claudia Garcia - Szekely

Losses force Firms to Exit Remaining firms’ market share increase The firm’s demand curve shifts right Existing firms can decrease advertising costs not necessary to defend market share anymore The firm’s ATC curve shifts down © 2000 Claudia Garcia - Szekely © 2000 Claudia Garcia - Szekely

ATC0 Like in Perfect Competition and Monopoly: firms may incur losses ATC1 Loss Pmc Pmc Like in Perfect Competition: Losses cause firms to exit The firm’s market share increase its ATC decrease due to lower advertising costs d1 d0 q0 q1 MR1 MR0 Demand and Costs shift until Losses disappear © 2000 Claudia Garcia - Szekely

Monopolistic Competition v.s Perfect Competition To improve Efficiency: Fewer firms, each producing more at the lowest ATC v.s Perfect Competition Markup Over MC MC ATC MC P d MR qmc P=MR P=MC ATC > min MC Min ATC qpc Excess Capacity: ATC > min No excess Capacity: ATC is min. © 2000 Claudia Garcia - Szekely

Monopolistic Competition Excess Capacity: should produce more v.s Monopoly ATC > min MC Monopolist can make profits in the long run! MC PMC PM Profit Markup Over MC Monopolistic competitors can NOT make profit in the long run Market Demand Market Share MC MC MCM d D qMC qM MR MR Excess Capacity: should produce more © 2000 Claudia Garcia - Szekely

Advertising and Monopolistic Competition Firms in a perfectly competitive market have no incentive to advertise: can sell any amount at the same price To sell more units, Monopolistic Competitors must drop the price or advertise to shift demand to the right. © 2000 Claudia Garcia - Szekely © 2000 Claudia Garcia - Szekely

Perfectly competitive firm Monopoly   Perfectly competitive firm Monopoly Monopolistic Competition Is entry into the market free or restricted? Is exit out of the industry free or restricted? How does the firm choose the output level? Does the firms charge one price? Or does it price discriminate? Shape of Demand faced by the firm Are producers price takers or price setters? Is MR greater than, less than or equal to Price? WHY? Do producers want to maximize profit or do they produce for some other reason? Do producers react to prices? In other words: is there a Supply curve in this market? Is the price charged greater than, smaller than or equal to MC? Can firm(s) make profit in the short run? Can firm(s) make profit in the long run? Can firm(s) incur a loss in the short run? Can firm(s) incur a loss in the long run?

© 2000 Claudia Garcia - Szekely