Introduction to Monopolistic Competition Module 67

Student Learning Objectives How prices and profits are determined in monopolistic competition, both in the SR and the LR How monopolistic competition can lead to inefficiency and excess capacity

Key Economic Concepts Firms in monopolistic competition have downward sloping demand curves because their products are differentiated from the products of their rivals. This gives firms some pricing power, and firms maximize profits by setting output where MR=MC In the SR, firms can earn economic profit if P>ATC, or can incur losses if P<ATC. In the LR, entry and exit causes firms to earn normal profits. LR equilibrium occurs at an output where P=ATC and the demand curve is tangent to the ATC curve.

Key Economic Concepts, continued Because firms do not produce the level of output where ATC is minimized, it is said that monopolistically competitive markets have excess capacity. Because P exceeds MC, DWL exists, but this inefficiency is offset by the many diverse products from which consumers can choose.

Common Student Difficulties If you recall the graph for a monopolist earning positive economic profit, then it will not be difficult to draw the SR graph in Mon Comp. The LR graph is more difficult. It is easier if you draw it backwards. First draw the demand curve tangent to the ATC curve and locate the LR price on the vertical axis. Then locate the output level directly below to the horizontal axis. Draw a MR curve that is below the demand curve and intersects the MC curve at the already-labeled level of output.

Common Student Difficulties, cont. Remember– anytime price is not equal to MC, there is DWL and inefficiency. The DWL found in this market structure, however, is less than what is found in monopoly because, with more firms competing, the wedge between price and MC is less severe.

Understanding Monopolistic Competition Shares characteristics with BOTH Monopoly and PC: Many firms exist but not as many as PC (dozens vs. hundreds) Product is differentiated Each firm has SOME price-making abilities There are no barriers to entry or exit Little opportunity for tacit collusion – too many firms (Strategy: Advertise)

Monopolistic Competition in the SR: positive economic profit

Monopolistic Competition in the SR: incurring economic loss

Monopolistic Competition in the SR: more elastic demand curve Why?? Many suppliers of close substitutes

Monopolistic Competition in the LR: positive economic profit Other firms see SR economic profit being made. – Attract entry to market – Demand and MR declines for existing firms (shift left), as there are many more similar products available to same # of consumers – Weaker demand  P falls – Lower P  Economic profits fall – Entry stops when normal profits are made

Monopolistic Competition in the LR: economics loss SR losses prompt exit from market Demand and MR for remaining firms shifts right, as there are fewer similar products available to the same # of consumers Stronger demand  prices rise Higher prices  economic loss to fall Entry stops when normal profits are made

What does this look like??

Monopolistic Competition vs. Perfect Competition Pricing power like monopoly but LR profits of $0 that look like PC firms Perfect Competition – LR level of output: P=MR=MC=ATC – Economic profits = 0 Monopolistic Competition – LR level of output: P=ATC>MR=MC – Economic profits = 0

Differences Profits are normal in both but P>MC in Mon Comp Where on ATC is P=ATC? – PC: P=ATC is at the min of ATC (Q corresponds to lowest ATC) – Mon Comp: P=ATC on the downward sloping range of ATC (smaller than the one that minimizes ATC = “EXCESS CAPACITY”

Is Monopolistic Competition Inefficient? In Monopoly, DWL exists when output stops anywhere before P=MC Anytime P does not = MC, there is inefficiency Mon Comp: P>MC  DWL exists There is more competition for consumers  the wedge between price and MC is lower in this market structure than it was in monopoly  DWL smaller than it was in Monopoly

Can we live with some DWL? Probably. The reason why P>MC is because firms have differentiated products that allows them some degree of pricing power DWL = “price of variety” – Mon Comp much preferred, despite DWL, to the PC version where all menus are the same