1. Monopolistic Competition Part II
Econ 201 Lecture 8.1a May 26, 2009
Monopolistic Competition
Part II

2. Characteristics of Monopolistic Competition
Similar to Perfect Competition
There are many producers in a given market.
There are few barriers to entry and exit
No extensive economies of scale
No dominant firm or firms
Differs from Perfect Competition
goods and services are heterogeneous
Consumers have clearly defined preferences and sellers attempt to differentiate their products from those of their competitors
means that producers have some degree of control over price

3. Overview Monopolistic Competition Market Demand is downward sloping
Result of product differentiation
So is firm demand, but it is smaller and more elastic than Market Demand
Firm sets price like a monopolist, but with less market power (more elastic)
Faces competition (cross-price elasticity)
Sets Price on the D curve where MR = MC

4. Overview Monopolistic Competitive firm Prices like a monopolist
Chooses MR = MC
Price > MC
However
Price for MC will be less than Monopolist
Closer to PC than M
Qty Supplied for Monop Compet Industry > Monopoly

5. Overview Monopolistic Competition Also resembles Perfect Competition
No economies of scale + free/ entry & exit
Market characterized by a many firms
Will drive long term economic profits to 0
Competitors produce “close” substitutes
Even with product differentiation – firms have only limited market (pricing) power (similar to “competitive fringe”)
Differs from Perfect Competition
Is not as efficient
Does not operate at min of LRAC
Allocatively inefficient (MV > MC)
“Excess Capacity” (too many firms/too much capital)
Does produce greater product variety

6. MC in the Short-Run Qs set where MR = MC
Earns + economic profit (monopoly rent)

7. MC in the Long-run
SR economic profits -> promote entry by new firms
Price will be “competed” down to LRAC
So no economic profit in LR
Firms will still not operate at min LRAC (unlike PC mkt)
More entry (unstable equilibria) & DWLoss

8. Characteristics of MC Markets
Departures from perfect competition
Differences in cost
Don’t operate at min of LRAC
Each firm may operate at different SRAC
Unstable equilibrium
Short-run (+) economic profits -> induce entry (minimal barriers) -> compete profits away
As newer, efficient firms enter -> older, less efficient exit -> “constructive” destruction (high rate of “turnover” like PC)
In the long-run,
Factors that differentiate products are duplicated by competing firms.
drives price down and,
monopolistically competitive firm will make zero economic profit (i.e. a rate of return equal to the rate required to compensate debt and equity holders for the risk of investing in the firm).
Unlike in perfect competition, the monopolistically competitive firm does not produce at the lowest attainable average total cost.

9. Examples of MC Markets
restaurants, cereal, clothing, shoes and service industries in large cities

10. Role of Advertising Basic Taxonomy of Advertising
From an economist’s perspective
1) Informational
Product quality, pricing, availability
“good gas at a good price”
2) Persuasive
Attempts to alter tastes and preferences with subjective information
No product or pricing info

11. Advertising Critics of monopolistic competition
fosters advertising and the creation of brand names.
advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors.
Refuted by defenders of advertising
(1) brand names can represent a guarantee of quality, and
(2) advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands.

12. Should We Regulate MC Markets?
Monopolistically competitive firms are inefficient, however:
usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits;
the government would have to regulate all firms that sold heterogeneous products
Consumers value variety, i.e., product differentiation