1. Principles of Microeconomics Chapter 16
Monopolistic Competition

2. Monopolistic Competition
Monopolistically Competitive Markets:
Have many buyers and sellers
Sell similar but differentiated products
Free entry and exit in the market
Firms:
Have some price control
In short run: experience economic profits + act as monopoly
In long run: zero economic profits + act as perfect competition

3. Writing to Learn Exercise
Log onto Amazon.com
Search for an ordinary consumer good (ie: soap, socks, tea ect.)
How many sellers do you find?
How many different varieties of the product can you find?
Do the prices differ?
How is this related to the concept of monopolistic competition?

4. Monopolistic Competition in Short Run
Firms have a “monopoly” on their differentiated good
Exert price control over their good
Can incur positive economic profits in short run!

5. In the short run… Market outcome looks similar to monopoly
Profit Max Point: MR = MC
Price > MR = MC
Determines quantity based on MR = MC
Determines price based on demand
If P > ATC
POSITIVE ECONOMIC PROFITS
Possible in Short Run

6. Firms in the long run operate at:
Market outcome similar to perfectly competitive markets
Reason: FREE ENTRY/EXIT
Firms in the long run operate at:
P > MC
Due to firm facing a downward sloping demand curve
P = ATC
Due to free entry and exit into the market

7. Firms in the long run operate at:
Market outcome similar to perfectly competitive markets
Reason: FREE ENTRY/EXIT
Firms in the long run operate at:
P > MC
Due to firm facing a downward sloping demand curve
P = ATC
Due to free entry and exit into the market

8. Firms in the long run operate at:
Market outcome similar to perfectly competitive markets
Reason: FREE ENTRY/EXIT
Firms in the long run operate at:
P > MC
Due to firm facing a downward sloping demand curve
P = ATC
Due to free entry and exit into the market

9. Long Run when P > ATC Adjust until P = ATC in Long run
If P > ATC: Short run positive profits
Overtime: more firms enter to take advantage of profits
Increase variety of goods as more firms enter
Decrease in demand for each firm’s differentiated good
Decrease in price for firms until P = ATC
Zero Economic Profits
In long run
Adjust until P = ATC in Long run

10. Short Run when P > ATC
Gina’s Soap Makers
Market for Soap MC
Price
(Cost)
Price MC S
ATC D MR D
Quantity
Quantity

11. Short Run when P > ATC
Gina’s Soap Makers
Market for Soap MC
Price
(Cost)
Price MC S P*
ATC P*
MR = MC D MR D Q*
Quantity
Quantity

12. Short Run when P > ATC
Gina’s Soap Makers
Market for Soap MC
Price
(Cost)
Price MC S P*
ATC
PROFIT P*
ATC D MR D Q*
Quantity
Quantity
In the short run – Gina’s Soap Makers Inc. is making a profit! Other firms observe this

13. Short Run to Long Run when P > ATC
Gina’s Soap Makers
Market for Soap MC
Price
(Cost)
Price MC S
S.2 P*
ATC
PROFIT
ATC D MR D Q*
Quantity
Quantity
New firms enter overtime to take advantage of the positive economic profits.
Supply curve shifts  increase in number of buyers

14. Long Run when P > ATC Gina’s Soap Makers Market for Soap MC Price
(Cost)
Price MC S
S.2
ATC P* P*
P**
P** D MR D
MR.2
D.2
Quantity
Q** Q*
Quantity Q*
Q**
As new firms enter  supply of soap in the market goes up
But for each individual firm  demand goes down because buyers have more options!
No change in costs  adjustment until P= ATC

15. Long Run when P > ATC Gina’s Soap Makers Market for Soap MC Price
(Cost)
Price MC S
S.2
ATC P* P*
P**
P** D MR D
MR.2
D.2
Quantity
Q** Q*
Quantity Q*
Q**
Price for soap in the market decreases
Quantity of soap available increases
Gina’s price for soap decreases
Quantity of soap she sells also decreases

16. Long Run when P < ATC Adjust until P = ATC in Long run
If P < ATC: Short run negative profits – Loss!
Overtime: firms exit market to avoid losses
Decrease variety of goods as more firms exit
Increase in demand for each firm’s differentiated good
Increase in price for firms that stay in market until P = ATC
Zero Economic Profits
In long run
Adjust until P = ATC in Long run

17. Application
Consider John’s Muffin Shop which is currently competing with many other bakeries selling similar pastries in a small town, but none as good as John’s (so he believes). Assume that because of the market dynamics, John finds himself selling his muffins at a price below the cost to produce each muffin.
Draw John’s Muffin Shop’s production decision graph as well as the market for pastries graph
Indicate what is happening in the short run for John’s Muffin Shop in terms of price, quantity, average total cost, and profit/loss.
What will happen in the long run for John’s Muffin Shop and the market for pastries? Illustrate to the best of your abilities.

18. Application Reflection
Why does this matter?
In the short run, monopolistically competitive firms can experience positive or negative economic profits depending on price and cost per unit (ATC).
Due to free entry/exit in this type of market – all firms will return to long run equilibrium with zero economic profits.
The number of firms in the market will continue to adjust until all firms are operating at this equilibrium and no single firm has the incentive to enter or leave the market.
What’s the most important takeaway?
Firms can tolerate negative economic profits temporarily, but eventually either they leave or, when other firms leave, the price adjusts so they operate with zero economic profits
Remember, economic profits include implicit/opportunity costs! So zero economic profits does not mean zero accounting profits!
MUDDIEST POINT?

19. Externalities in M. C. Market
Positive for the consumer
Negative for the business
Product Variability Externality
Business Stealing Externality
Consumers are better off with more choices!
So when new firms enter a market – consumers benefit because there are more varieties of the product to choose from
Existing firms suffer when new firms enter a market
More variety means less demand for the existing products
New firms steal business, demand and consumers for the goods of existing firms

20. Externalities in M. C. Market
Positive for the consumer
Negative for the business
Product Variability Externality
Business Stealing Externality
Consumers are better off with more choices!
So when new firms enter a market – consumers benefit because there are more varieties of the product to choose from
Existing firms suffer when new firms enter a market
More variety means less demand for the existing products
New firms steal business, demand and consumers for the goods of existing firms

21. Externalities in M. C. Market
Positive for the consumer
Negative for the business
Product Variability Externality
Business Stealing Externality
Consumers are better off with more choices!
So when new firms enter a market – consumers benefit because there are more varieties of the product to choose from
Existing firms suffer when new firms enter a market
More variety means less demand for the existing products
New firms steal business, demand and consumers for the goods of existing firms

22. Key Takeaways
Monopolistically Competitive firms act as both monopolies (in SR) and perfectly competitive firms (in LR)
Have some excess capacity and mark up because have some price control
Advertising only works when there are similar but differentiated products – only in M.C. markets