1. INTRODUCTION TO MICROECONOMICS Topic 8 Monopolistic Competition These slides are copyright © 2010 by Tavis Barr. This work is licensed under a Creative Commons Attribution- ShareAlike 3.0 Unported License. See http://creativecommons.org/licenses/by-sa/3.0/ for further information.http://creativecommons.org/licenses/by-sa/3.0/

2. Topic Outline ● Monopolistic Competition – Short run – Long run ● Perfect Competition – Short run – Long run – Efficiency properties

3. Monopolistic Competition ● Firms sell differentiated products – Retail stores have different locations – Brands of clothing are slightly different ● Lots of buyers and sellers ● Free Entry and Exit

4. Monopolistic Competition ● Free entry and exit means that firms will enter industry whenever there is money to be made ● Economic profit: earnings on an investment above the average rate of return (e.g. what you get if you invest it in the stock market) – Can be zero when accounting profit (i.e., that reported on the balance sheet) is positive – Reflects opportunity cost of not using capital resources elsewhere

5. Monopolistic Competition ● Free entry and exit means that firms will enter industry whenever there is money to be made ● Economic profit: earnings on an investment above the average rate of return (e.g. what you get if you invest it in the stock market) ● If there is economic profit, firms will enter ● If there are economic losses, firms will leave

6. Monopolistic Competition ● Firm entry: Shifts in the demand curve of competitors – Smaller quantity demanded at same price ● Firm exit: Shifts out the demand curve of competitors Exit Entry

7. Monopolistic Competition ● Short run: – Fixed inputs are chosen; no entry and exit – Exactly like monopoly – Firms choose quantity from MR=MC, price from demand curve

8. Monopolistic Competition ● Long run: Average cost comes into play – Profits: TR – TC – Recall that TR = P x Q – Recall that AC = TC / Q, so TC = AC x Q – Thus, profits are ∏ = Q x (P - AC)

9. Monopolistic Competition ● Profits are ∏ = Q x (P – AC) ● If P > AC, profits are positive; firms enter Firms will enter: P > AC

10. Monopolistic Competition ● Profits are ∏ = Q x (P – AC) ● If P > AC, profits are positive; firms enter ● If P < AC, there are losses; firms leave Firms will leave: P < AC

11. Monopolistic Competition ● Profits are ∏ = Q x (P – AC) ● If P > AC, profits are positive; firms enter ● If P < AC, there are losses; firms leave ● If P = AC, zero profit; no entry or exit No entry or exit: P = AC MR=MC

12. Monopolistic Competition Long run equilibrium: Two conditions ● MR = MC ● P = AC No entry or exit: P = AC MR=MC

13. Monopolistic Competition Efficiency results: ● MR = MC ● But P > MR ● So, like monopoly, price is too high and output (per firm, anyway) is too low No entry or exit: P = AC MR=MC Efficient Level: P=MC

14. Monopolistic Competition Efficiency results: ● Like monopoly, price is too high and output too low ● What if we forced P=MC? – Each firm would be bigger – There would be fewer firms (maybe a bad thing) – This problem is called excess variety MR=MC No entry or exit: P = AC Efficient Level: P=MC

15. Perfect Competition ● Perfect competition is a special case of monopolistic competition ● The special case: The demand curve perceived by an individual firm is completely flat – A flat demand curve is called infinitely or perfectly elastic

16. Perfect Competition ● Note that flat demand for an individual firm's products is not the same as a perfectly elastic industry-wide demand ● The idea: – Products are identical – Lots and lots of firms – If a firm raises its price by a penny, consumers will defect

17. Perfect Competition ● What does marginal revenue look like when the demand curve is flat? QP 080 180 280 380 480 etc.

18. Perfect Competition ● What does marginal revenue look like when the demand curve is flat? QPTR 0800 18080 280160 380240 480320 etc.

19. Perfect Competition ● What does marginal revenue look like when the demand curve is flat? QPTRMR 0800- 1808080 28016080 38024080 48032080 etc.

20. Perfect Competition ● What does marginal revenue look like when the demand curve is flat? QPTRMR 0800- 1808080 28016080 38024080 48032080 etc. The result: P = MR

21. Perfect Competition How perfect competitors set output and prices ● Like monopolists and anyone else: Output at MR=MC ● But P = MR ● So set output where P = MC ● Because demand and MR are the same, this also tells us the price – E.g., price is $80, output 4

22. Perfect Competition Another example of pricing ● Suppose a perfect competitor has this cost function: QTC 060 190 2110 3140 4200 5280 6390

23. Perfect Competition Another example of pricing: QTCMC 060- 19030 211020 315040 420050 528080 6390110

24. Perfect Competition Another example of pricing: QTCMC 060- 19030 211020 315040 420050 528080 6390110 What if P = $50?

25. Perfect Competition Another example of pricing: QTCMC 060- 19030 211020 315040 420050 528080 6390110 What if P = $50? Firm chooses Q=4.

26. Perfect Competition Another example of pricing: QTCMC 060- 19030 211020 315040 420050 528080 6390110 What if P = $80?

27. Perfect Competition Another example of pricing: QTCMC 060- 19030 211020 315040 420050 528080 6390110 What if P = $80? Firm chooses Q=5.

28. Perfect Competition Perect Competition and Efficiency ● Recall short-run rule for setting output: P (= MR) = MC ● This is also the rule for a Pareto efficient level of output: P = MC ● Conclusion: Easier switching means more Pareto efficiency

29. Perfect Competition The Short-Run Supply Curve ● The marginal cost curve traces out the quantity a firm is willing to produce at a given price ● The higher the price, the more the firm will make ● We call this line the firm's supply curve: The curve showing the quantity it will make at a given price

30. Perfect Competition Short-Run Industry Supply ● An industry is made of of firms, each of which gets its quantity from the MC curve at that price ● Therefore, at a given price, the industry will supply a quantity that is the sum of the quantity in each firm's MC curve at that price

31. Perfect Competition Short-Run Industry Supply ● At a given price, the industry will supply a quantity that is the sum of the quantity in each firm's MC curve at that price ● We say that the industry supply curve is the horizontal sum of each firm's supply curve

32. Perfect Competition Long-Run Equilibrium ● Like regular monopolistic compeition: – Firms enter when P > AC – Pushes price down toward average cost

33. Perfect Competition Long-Run Equilibrium ● Like regular monopolistic competition: – Firms leave when P < AC – Pushes price up toward average cost

34. Perfect Competition Long-Run Equilibrium ● Like regular monopolistic competition: – When P > AC, entry pushes price down – When P > AC, Entry pushes price up – Long-run equilibrium: P = AC, just like regular monopolistic competition

35. Perfect Competition Long-Run Equilibrium: Efficiency Properties ● In both short and long run: P = MC ● In long run: P = AC ● Therefore, in long run: AC = P = MR = MC

36. Perfect Competition Long-Run Equilibrium: Efficiency Properties ● In both short and long run: P = MC ● In long run: P = AC ● Therefore, in long run: AC = P = MR = MC

37. Cost Function (Deja Vu) The relationship between average and marginal cost ● If MC < AC, then AC is falling ● If MC > AC, then AC is rising ● If MC=AC, then AC is minimized (or maximized)

38. Perfect Competition Long Run Equilibrium: Efficiency Properties ● If MC=AC, then AC is minimized (or maximized) ● Long run equilibrium under perfect competition: MC = AC ● Therefore, average cost is minimized