1. Monopolistic Competition
Economics 101

2. Definition Monopolistic Competition
Many firms selling products that are similar but not identical.
Markets that have some features of competition and some features of monopoly.

3. Attributes Attributes of Monopolistic Competition Many sellers
Product differentiation
Free entry and exit

4. Attribute 1 Many Sellers
There are many firms competing for the same group of customers.
Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc.

5. Attribute 2 Product Differentiation
Each firm produces a product that is at least slightly different from those of other firms.
Rather than being a price taker, each firm faces a downward-sloping demand curve.

6. Attribute 3 Free Entry or Exit
Firms can enter or exit the market without restriction.
The number of firms in the market adjusts until economic profits are zero.

7. Short-Run Economic Profits
The Monopolistically Competitive Firm in the Short Run
Short-run economic profits encourage new firms to enter the market. This:
Increases the number of products offered.
Reduces demand faced by firms already in the market.
Incumbent firms’ demand curves shift to the left.
Demand for the incumbent firms’ products fall, and their profits decline.

8. (a) Firm Makes Profit Price MC ATC Demand MR Profit- maximizing
quantity
Price
Average
total cost
Profit
Quantity
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9. Short-Run Economic Losses
The Monopolistically Competitive Firm in the Short Run
Short-run economic losses encourage firms to exit the market. This:
Decreases the number of products offered.
Increases demand faced by the remaining firms.
Shifts the remaining firms’ demand curves to the right.
Increases the remaining firms’ profits.

10. (b) Firm Makes Losses Price MC ATC Losses Loss- minimizing quantity
Average
total cost
Demand
Price MR
Quantity
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11. Long-Run Equilibrium
Firms will enter and exit until the firms are making exactly zero economic profits.

12. Price MC ATC Demand MR Profit-maximizing quantity P = ATC Quantity
Quantity
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13. Characteristics of Long-Run Equilibrium
Two Characteristics
As in a monopoly, price exceeds marginal cost.
Profit maximization requires marginal revenue to equal marginal cost.
The downward-sloping demand curve makes marginal revenue less than price.
As in a competitive market, price equals average total cost.
Free entry and exit drive economic profit to zero.

14. Monopolistic versus Perfect Competition
There are two noteworthy differences between monopolistic and perfect competition—excess capacity and markup.

15. Excess Capacity Excess Capacity
There is no excess capacity in perfect competition in the long run.
Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm.
There is excess capacity in monopolistic competition in the long run.
In monopolistic competition, output is less than the efficient scale of perfect competition.

16. (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price
Price MC
ATC MC
ATC
Demand MR P
Quantity
produced
Efficient
scale P = MC MR
(demand
curve)
Quantity produced =
Efficient scale
Quantity
Quantity
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17. Markup Markup Over Marginal Cost
For a competitive firm, price equals marginal cost.
For a monopolistically competitive firm, price exceeds marginal cost.
Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm.

18. (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price
Price MC
ATC MC
ATC
Markup
Demand MR P
Quantity
produced P = MC MR
(demand
curve)
Quantity produced
Marginal
cost
Quantity
Quantity
Copyright©2003 Southwestern/Thomson Learning

19. (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price
Price MC
ATC MC
ATC
Markup
Demand MR P
Quantity
produced
Efficient
scale P = MC MR
(demand
curve)
Quantity produced =
Efficient scale
Marginal
cost
Quantity
Quantity
Excess capacity
Copyright©2003 Southwestern/Thomson Learning

20. Monopolistic Competition and Welfare of Society
Monopolistic competition does not have all the desirable properties of perfect competition.
There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.

21. Monopolistic Competition and Welfare of Society
However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.
Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.

22. Advertising When firms Then, they have incentive to advertise
Sell differentiated products
At price above marginal cost
Then, they have incentive to advertise
To attract more buyers

23. Advertising Debate over advertising The critique of advertising
Firms advertise to manipulate people’s tastes
Psychological rather than informational
Creates a desire that otherwise might not exist
Impedes competition
Increase perception of product differentiation
Foster brand loyalty
Makes buyers less concerned with price differences among similar goods

24. Advertising Debate over advertising The defense of advertising
Provide information to customers
Customers - make better choices
Enhances the ability of markets to allocate resources efficiently
Fosters competition
Customers - take advantage of price differences
Allows new firms to enter more easily

25. Advertising Advertising as a signal of quality
Advertising – little apparent information
Real information offered – a signal
Willingness to spend large amount of money
= signal about quality of the product
Content of advertising = irrelevant

26. Advertising Brand names Firm – brand name Critics of brand names
Spend more on advertising
Charge higher prices
Than generic substitutes
Critics of brand names
Products – not differentiated
Irrationality: consumers are willing to pay more for brand names

27. Advertising Brand names Defenders of brand names Useful: high quality
Consumers – information about quality
Firms – incentive to maintain high quality

28. Monopolistic competition: between perfect competition& monopoly1
Monopolistic competition: between perfect competition& monopoly
Market structure
Perfect
competition
Monopolistic
Monopoly
Features that all three market structures share
Goal of firms
Rule for maximizing
Can earn economic profits in the short run?
Features that monopolistic competition shares with monopoly
Price taker?
Price
Produces welfare-maximizing level of output?
Features that monopolistic competition shares with competition
Number of firms
Entry in long run?
Can earn economic profits in long run?
Maximize profits
MR = MC
Yes
P = MC
Many No
P > MC
One