1. Unit 5: Monopoly, Monopolistic Competition, and Oligopoly
Lecture #2, Monopolistic Competition
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. Think and Compare Before moving forward…
Think about the characteristics of the market structures we have studied
Think about how monopolistically competitive firms are similar/dissimilar to those that are perfectly competitive or monopolists
In monopolistic competition, firms can differentiate their products by the product attributes, by service, with location, or with brand names and packaging. There is relatively easy entry and exit, just not as easy as with perfect competition. That is why the number of sellers is not as large as in perfect competition, but it is relatively large. This type of market experiences some pricing power due to the differentiated product. If a firm goes to the trouble and expense of differentiating their product they should let people know about it. They can do this through advertising.
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3. Monopolistic Competition
Relatively large number of sellers
Differentiated products
Easy entry and exit
Need to advertise
In monopolistic competition, firms can differentiate their products by the product attributes, by service, with location, or with brand names and packaging. There is relatively easy entry and exit, just not as easy as with perfect competition. That is why the number of sellers is not as large as in perfect competition, but it is relatively large. This type of market experiences some pricing power due to the differentiated product. If a firm goes to the trouble and expense of differentiating their product they should let people know about it. They can do this through advertising.
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4. Monopolistically Competitive
Based on # of firms in an industry and percent of market share
Measured by two methods:
Four-firm Concentration Ratios
Percentage of market held by 4 largest firms
Herfindahl Index
Measured by summing squared % of market shares held by firms in an industry
10,000 is the highest (1 firm with 100% of the market = 1002
Four-firm concentration ratios are a measure of industry concentration. Four-firm concentration ratios are low in monopolistically competitive firms as in the table on the next slide. One of the cautions of using these is that they reflect national output (sales numbers) and would not be reflective of a localized monopoly.
Herfindahl index – the lower the HI, the more competitive the industry. The Herfindahl Index is another measure of industry concentration and it is the sum of the squared percentage of market shares of all firms in the industry. Generally speaking, the lower the Herfindahl, the lower the industry concentration.
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5. Low Concentration Industries
(1)
Industry
(2)
4-Firm Concentration Ratio
(3)
Herfindahl
Index
Asphalt paving 25
207
Metal windows and doors 14
114
Plastic pipe 24
262
Women’s dresses 13 84
Textile bags
263
Ready mix concrete 11 63
Bolts, nuts, and rivets
205
Wood trusses 10 50
Plastic bags 23
240
Stone products 59
Quick printing 22
319
Metal stamping 8 31
Textile machinery 20
206
Wood pallets 7
Sawmills 18
117
Sheet metal work 6
Jewelry 16
Signs 5 19
Curtains and draperies
111
Retail bakeries 4
This table shows some examples of U.S. manufacturing industries that are considered monopolistically competitive. The lower the 4-firm concentration ratio, the less concentration and subsequently, the more competitive the industry. Generally speaking, the lower the Herfindahl index, the lower the industry concentration.
Source: Bureau of Census, Census of Manufacturers, 2002
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6. Price and Output in Monopolistic Comp
Demand is highly elastic
Short-run profit or loss occur
Produce where MR=MC
Only long-run normal profit
Firms enter and exit based on profit opportunity
Inefficient
Product variety
The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price.
In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly.
The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that.
Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient.
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7. Price and Output in Monopolistic Comp
Produce where P > MC
Not socially optimal output
Deadweight Loss results
Not possible to regulate
Too many firms
Too many differentiated products
The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price.
In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly.
The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that.
Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient.
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8. The Short Run: Profit Price and Costs Quantity ATC MC P1 A1 Economic
MR = MC
Firms produce the quantity where MR = MC just like in other industries. It is possible to make a profit in the short run. (Price – ATC) * Q = Economic profit.
At the profit maximizing output, price is higher than ATC and the firms enjoy an economic profit in the short run. MR Q1
Quantity
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9. The Short Run: Profit
Short-run economic profits encourage new firms to enter the market. This:
Increases the number of products.
Reduces demand of current firms.
Current firms profits fall.
The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price.
In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly.
The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that.
Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient.
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10. The Short Run: Loss Price and Costs Loss Quantity ATC MC A2 P2 D2
MR = MC
Firms will produce the quantity where MR = MC to maximize profits. It is possible to make a loss in the short run. (Price – ATC) * Q = Economic profit or loss. At the profit maximizing output, price is below ATC and therefore a loss is incurred. MR Q2
Quantity
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11. The Short Run: Loss
Short-run economic losses encourage firms to exit the market. This:
Decreases the number of products.
Increases demand of remaining firms.
Increases the remaining firms’ profits.
The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price.
In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly.
The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that.
Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient.
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12. The Long Run: Only a Normal ProfitMC
ATC
P3= A3
Price and Costs D3
MR = MC
In the long run firms still produce the quantity where MR = MC. In the long run firms will enter the industry if economic profits were enjoyed, shifting demand left and profits fall. In the long run firms will exit the industry if there are economic losses, shifting demand to the right and losses shrink. This will continue until the price settles where it just equals ATC at the MR=MC output. At this price, the monopolistically competitive firm earns a normal profit. MR Q3
Quantity
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13. Long-Run Normal Profits
Why do monopolistically competitive firms only earn normal profits in the long-run?
The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price.
In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly.
The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that.
Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient.
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14. Monopolistic Competition: Efficiency
Inefficient use of resources
Excess capacity (not found in Perfect Comp)
Productive inefficiency
P > ATC
Additional capacity possible if production occurred at ATC
Allocative inefficiency
P > MC
Resources could be better-used with a different product
Productive Efficiency means that the firm is producing in the least costly way and is evidenced when P = min ATC.
Allocative Efficiency means that the firm is producing the right amount of output and is evidenced when P = MC.
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15. Monopolistic Competition: Not Efficient
P=MC=Min ATC for pure competition (recall)
Quantity
Price and Costs
MR = MC MC MR D3
ATC Q3
P3= A3 P4
Price is Lower
We can see the inefficiency of monopolistic competition. In long-run equilibrium a monopolistic competitor achieves neither productive nor allocative efficiency. Productive efficiency is not realized because production occurs where the average total cost A3 exceeds the minimum average total cost A4. Allocative efficiency is not achieved because the product price P3 exceeds the marginal cost. The results are an underallocation of resources as well as an efficiency loss and excess production capacity for every firm in the industry. This firm’s excess production capacity is Q4 - Q3.
Excess Capacity at
Minimum ATC Q4
Monopolistic competition is not efficient
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16. Product Variety
The firm constantly manages price, product, and advertising.
Better product differentiation
Better advertising
The consumer benefits by greater array of choices and better products.
Types and Styles
Brands and Quality
Monopolistically competitive producers may be able to postpone the long-run outcome of just normal profits through product development, improvement, and advertising. Compared with pure competition, this suggests possible advantages for the consumer. Development, or improved products, can provide the consumer with a diversity of choices.
Product differentiation is at the heart of the trade-off between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem.
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17. Advertising and Branding
Does advertising increase competition and provide useful information to consumers or is it used to simply manipulate our tastes and preferences?
Are brand names an indicator of quality or do they cause consumers to perceive differences that do not really exist?
Monopolistically competitive producers may be able to postpone the long-run outcome of just normal profits through product development, improvement, and advertising. Compared with pure competition, this suggests possible advantages for the consumer. Development, or improved products, can provide the consumer with a diversity of choices.
Product differentiation is at the heart of the trade-off between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem.
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