1. ECONOMICS Paul Krugman | Robin Wells with Margaret Ray and David Anderson SECOND EDITION in MODULES

2. MODULE 31 (67) Introduction to Monopolistic Competition Krugman/Wells

3. How prices and profits are determined in monopolistic competition, both in the short run and the long run How monopolistic competition can lead to inefficiency and excess capacity 3 of 22

4. Product Differentiation Product differentiation plays an even more crucial role in monopolistically competitive industries. Why? Tacit collusion is virtually impossible when there are many producers. Product differentiation is the only way monopolistically competitive firms can acquire some market power. 4 of 22

5. Understanding Monopolistic Competition Monopolistic competition combines some features typical of monopoly with others typical of perfect competition. 5 of 22

6. Understanding Monopolistic Competition Because each firm is offering a distinct product, it is in a way like a monopolist. It faces a downward-sloping demand curve. It has some market power—the ability (within limits) to determine the price of its product. 6 of 22

7. Understanding Monopolistic Competition Unlike a pure monopolist, a monopolistically competitive firm does face competition. The amount of its product it can sell depends on the prices and products offered by other firms in the industry. 7 of 22

8. The MC Firm in the Short Run The following figure shows two possible situations that a typical firm in a monopolistically competitive industry might face in the short run. 8 of 22

9. The MC Firm in the Short Run In each case, the firm looks like any monopolist: it faces a downward-sloping demand curve, which implies a downward-sloping marginal revenue curve. We assume that every firm has an upward-sloping marginal cost curve, but that it also faces some fixed costs, so that its average total cost curve is U-shaped. 9 of 22

10. The MC Firm in the Short Run D P Profit Loss MR P ATC (a) A Profitable Firm (b) An Unprofitable Firm Q P P P Quantity ATC P D U MR U MC ATC Q U P U Quantity ATC U Profit-maximizing quantity Loss-minimizing quantity MC Price, cost, marginal revenue 10 of 22

11. Monopolistic Competition in the Long Run If the typical firm earns positive profits, new firms will enter the industry in the long run, shifting each existing firm’s demand curve to the left. If the typical firm incurs losses, some existing firms will exit the industry in the long run, shifting the demand curve of each remaining firm to the right. 11 of 22

12. Entry and Exit Shift Existing Firm’s Demand Curve and Marginal Revenue Curve (a) Effects of Entry(b) Effects of Exit Exit shifts the existing firm’s demand curve and its marginal revenue curve rightward. MR 2 2 1 1 D 1 D 1 D 2 D 2 Entry shifts the existing firm’s demand curve and its marginal revenue curve leftward. Price, marginal revenue Quantity 12 of 22

13. Monopolistic Competition in the Long Run In the long run, a monopolistically competitive industry will end up in zero-profit-equilibrium. Each firm makes zero profit. The typical firm’s demand curve is just tangent to its average total cost curve at its profit-maximizing output. 13 of 22

14. The Long-Run Zero-Profit Equilibrium MR MC D ATC Z Q P =ATC Point of tangency Price, cost, marginal revenue Quantity 14 of 22

15. Hits and Flops The movie industry seems to meet the criteria for monopolistic competition. Where’s the zero profit equilibrium? For every successful film, there are several flops. The movie industry on average earns just enough to cover the cost of production. 15 of 22

16. Monopolistic Competition versus Perfect Competition In the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit. Price exceeds marginal cost, so some mutually beneficial trades are exploited. 16 of 22

17. Monopolistic Competition versus Perfect Competition The following figure compares the long-run equilibrium of a typical firm in a perfectly competitive industry with that of a typical firm in a monopolistically competitive industry. 17 of 22

18. Comparing LR Equilibrium in PC and MC MC ATC (b) Long-Run Equilibrium in Monopolistic Competition MC ATC P = ATC Q PC Q MC D MR MC P PC = MC PC = ATC D=MR=P PC (a) Long-Run Equilibrium in Perfect Competition Price, cost, marginal revenue Minimum-cost output Quantity 18 of 22

19. Is Monopolistic Competition Inefficient? Firms in a monopolistically competitive industry have excess capacity. They produce less than the output at which average total cost is minimized. 19 of 22

20. Is Monopolistic Competition Inefficient? Price exceeds marginal cost, so some mutually beneficial trades are unexploited. The higher price consumers pay because of excess capacity is offset to some extent by the value they receive from greater diversity. Hence, it is not clear that this is a source of inefficiency. 20 of 22

21. 1.Short-run profits will attract entry of new firms in the long run. This reduces the quantity each existing producer sells at any given price and shifts its demand curve to the left. 2.Short-run losses will induce exit by some firms in the long run. This shifts the demand curve of each remaining firm to the right. 3.In the long run, a monopolistically competitive industry is in zero-profit equilibrium: at its profit-maximizing quantity, the demand curve for each existing firm is tangent to its average total cost curve. 21 of 22

22. 4.In long-run equilibrium, firms in a monopolistically competitive industry sell at a price greater than marginal cost. 5.They also have excess capacity because they produce less than the minimum-cost output; as a result, they have higher costs than firms in a perfectly competitive industry. 22 of 22