1. Monopolistic Competition
CHAPTER 16
Monopolistic Competition
Examples of monopolistic competition are everywhere: the clothes students wear, the fancy frozen coffee drinks they slurp up on their way to class, the magazines they read, the nightclubs where they dance.
As a result, students find the theory of monopolistic competition more relevant than the theory of perfect competition, which best describes products like wheat and soybeans, products that few students ever consider buying.
The last part of the chapter, on advertising and brand names, is especially interesting & useful for business students.
If students are reasonably comfortable with the material on perfect competition and monopoly, then this chapter should not be difficult. It is also shorter than average.
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2. Look for the answers to these questions:
What market structures lie between perfect competition and monopoly, and what are their characteristics?
How do monopolistically competitive firms choose price and quantity? Do they earn economic profit?
How does monopolistic competition affect society’s welfare?
What are the social costs and benefits of advertising?
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

3. Introduction Two extremes
Perfect competition: many firms, identical products
Monopoly: one firm
Imperfect competition – in between the extremes:
Oligopoly: only a few sellers offer similar or identical products.
Monopolistic competition: many firms sell similar but not identical products.
In the preceding two chapters, we studied the two extremes of the competition spectrum. This chapter focuses on monopolistic competition, one of the market structures in between the two extremes.
Examples of each market type:
Perfect competition: wheat, milk
Monopoly: tap water, cable TV
Oligopoly: tennis balls, cigarettes (we study oligopoly in the next chapter)
Monopolistic competition: novels, movies
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4. Monopolistic Competition
Characteristics:
Many sellers
Product differentiation
Not price takers; downward sloping D curve
Free entry and exit
Zero economic profit in the long run
Examples of monopolistic competition:
Apartments, books, bottled water, clothing, fast food, night clubs
While not all are emphasized in the book, here are some ways producers differentiate their products are: actual physical differences (a 30” TV offers a different Super Bowl experience than a 70” TV, right?), advertising (or branding; ), and location.
Gasoline seems like an undifferentiated product, yet different gas stations charge different prices. How can some gas stations get away with charging 5 or even 10 cents more per gallon? The answer is product differentiation by location.
Imagine you’re driving home in rush-hour traffic from a grueling 10-hour day at the office. The orange warning light comes on, indicating your car needs gas. After uttering a few choice expletives, you notice two gas stations at an upcoming intersection. The one on the right charges 5 cents more than the one on the left, but is easily accessible. The one on the left would require you to make a left-hand turn in heavy traffic to get into the station, and another to get out. And how much would you save? If you buy 20 gallons, you’d save only $1.
Alternatively, imagine you run a gas station located in a highly residential area, in which there are few other businesses—including gas stations. If people want gas, they can buy it from you, or they can drive 10 minutes to a more commercial area with lots of gas stations. Your location allows you to charge a higher price.
Businesspeople have long understood that location is a critical dimension of product differentiation. Hence the saying “location, location, location.”
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5. Comparisons Perfect Monopolistic Competition Competition Monopoly
Number of sellers Many Many One
Free entry/exit Yes Yes No
Long-run
economic profits Zero Zero Positive
The products No close
firms sell Identical Differentiated substitutes
Firm has market None;
power? price-taker Yes Yes
D curve Downward Downward-
facing firm Horizontal sloping sloping (market D)
Monopolistic competition
- Long-run profits for are zero because of free entry/exit.
- The market power: it sells a product that is at least somewhat different from products sold by other firms.
- The D curve is downward-sloping because the firm has a bit of market power and sells a unique variety.
A monopoly is the sole seller of a product with no close substitutes. In contrast, the monopolistic competitor sells a product with many close substitutes. As a result, demand for the monopolist’s product is less elastic than demand for the monopolistic competitor’s product.
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6. Short Run Equilibrium
Profit maximization in the short-run for the monopolistically competitive firm:
Produce the quantity where MR = MC
Price: on the demand curve
If P > ATC: profit
If P < ATC: loss
Similar to monopoly
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7. A Monopolistically Competitive Firm Earning Profits in the Short RunMC
ATC
The firm faces a downward-sloping D curve.
At each Q, MR < P.
To maximize profit, firm produces Q where MR = MC.
The firm uses the D curve to set P.
Quantity
Price
profit D P MR
ATC Q
The graphical analysis of the monopolistically competitive firm’s output, price, and profits/losses is very similar to that of the monopoly firm.
One subtle difference is that the demand curve (and MR curve) facing the monopolistically competitive firm is likely to be flatter than the demand curve facing the monopolist, as the monopolistic competitor faces competition from other firms selling similar products.
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8. A Monopolistically Competitive Firm With Losses in the Short RunMC
ATC
Quantity
Price
For this firm, P < ATC at the output where MR = MC.
The best this firm can do is to minimize its losses.
losses
ATC D P MR Q
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9. Long Run Equilibrium
If monopolistically competitive firms are making profit in short run
New firms: incentive to enter the market
Increase number of products
Reduces demand faced by each firm
Demand curve shifts left; prices fall
Each firm’s profit declines to zero
If losses in the short run:
Some firms exit the market, remaining firms enjoy higher demand and prices
Short run: Under monopolistic competition, firm behavior is very similar to monopoly.
Long run: In monopolistic competition, entry and exit drive economic profit to zero.
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10. A Monopolistic Competitor in the Long RunMC
Entry and exit occurs until P = ATC and profit = zero.
Notice that the firm charges a markup of price over marginal cost and does not produce at minimum ATC.
ATC
Quantity
Price
P = ATC
markup D
The level of output that minimizes ATC is greater than the output that maximizes the monopolistic competitor’s profits. Hence, we say the monopolistic competitor operates with excess capacity. (More on this topic on the next slide.) MC MR Q
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11. Monopolistic competition
Why Monopolistic Competition Is Less Efficient than Perfect Competition
Monopolistic competition
Excess capacity: quantity is not at minimum ATC (it is on the downward-sloping portion of ATC)
Markup over marginal cost: P > MC
Perfect competition
Quantity: at minimum ATC (efficient scale)
P = MC
Due to the markup of price over marginal cost, the market output under monopolistic competition will be smaller than the socially efficient output, as we discuss on the following slide.
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12. Welfare of Society Monopolistically competitive markets
Do not have all the desirable welfare properties of perfectly competitive markets
Sources of inefficiency
Markup of price over marginal cost
Too much or too little entry (number of firms in the market)
Product-variety externality
Business-stealing externality
Each of the sources of inefficiency is discussed in more detail on the following slide.
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13. Welfare of Society Markup, P > MC
Market quantity < socially efficient quantity
Deadweight loss of monopoly pricing
The product-variety externality:
Consumers get extra surplus from the introduction of new products
The business-stealing externality:
Losses incurred by existing firms when new firms enter market
The problem of markup pricing facing policymakers here is similar to the problem arising from natural monopoly:
With natural monopoly, ATC is always falling, so MC is below ATC. If regulators force a natural monopoly to price at marginal cost, it will incur losses. Yet, not easy for policymakers to fix this problem: Firms earn zero profits, so cannot require them to reduce prices.
The product-variety externality is a positive one for consumers; while the business-stealing externality is a negative one on existing producers. It’s not clear which externality effect is bigger, and it may in fact differ by industry.
The inefficiencies of monopolistic competition are subtle and hard to measure. No easy way for policymakers to improve the market outcome.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

14. Active Learning 1 Advertising
So far, we have studied three market structures: perfect competition, monopoly, and monopolistic competition.
In each of these, would you expect to see firms spending money to advertise their products? Why or why not?
Is advertising good or bad from society’s viewpoint? Try to think of at least one “pro” and “con.”
Consider breaking up your lecture with a 10 minute discussion. First, give your students a few quiet moments to formulate their responses. Then, ask for volunteers to share their answers. If you have a chalkboard or dry-erase board, concisely paraphrase each student’s response as it is volunteered. If a student volunteers a “wrong” answer, write it down anyway. After the class has generated a list, have the class go over each item on the list to make sure it really belongs on the list.
Benefits:
1) Breaks up the lecture into chunks.
2) Engages students.
3) Gets students to think about the implications of the market structures they’ve studied so far. (Hopefully, some will recognize that product differentiation is a critical determinant of firms’ motivation to spend on advertising.)
4) Makes students feel invested in learning the second half of the chapter.
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15. Advertising Incentive to advertise Advertising spending
When firms sell differentiated products and charge prices above marginal cost
Advertise to attract more buyers
Advertising spending
Highly differentiated goods: 10-20% of revenue
Industrial products: Little advertising
Homogenous products: No advertising
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

16. Advertising In monopolistically competitive industries
Product differentiation and markup pricing lead naturally to the use of advertising
The more differentiated the products
The more advertising firms buy
Economists disagree about the social value of advertising:
Wasting resources?
Valuable purpose?
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

17. The Critique of Advertising
Firms advertise to manipulate people’s tastes
Psychological rather than informational
Creates a desire that otherwise might not exist
Advertising impedes competition
Increase perception of product differentiation
Foster brand loyalty; higher markups
Makes buyers less concerned with price differences among similar goods
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18. The Defense of Advertising
It provides useful information to buyers
Informed buyers can more easily find and exploit price differences
Advertising promotes competition and reduces market power
Results of a prominent study:
Eyeglasses were more expensive in states that prohibited advertising by eyeglass makers than in states that did not restrict such advertising
The study mentioned here was by economist Lee Benham, published in the Journal of Law and Economics in The textbook has a case study that discusses this research in more detail.
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19. Advertising Advertising as a signal of quality
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
A firm’s willingness to spend huge amounts on advertising may signal the quality of its product to consumers, regardless of the content of ads.
Ads may convince buyers to try a product once, but the product must be of high quality for people to become repeat buyers.
The most expensive ads are not worthwhile unless they lead to repeat buyers.
When consumers see expensive ads, they think the product must be good if the company is willing to spend so much on advertising.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

20. Brand Names
In many markets, brand name products coexist with generic ones.
Brand names
Spend more on advertising and charge higher prices than generic substitutes
As with advertising, there is disagreement about the economics of brand names…
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21. Advertising Critics of brand names Defenders of brand names
Products – not differentiated
Irrationality: consumers are willing to pay more for brand names
Defenders of brand names
Consumers – information about quality
Firms – incentive to maintain high quality to protect the reputation of their brand name
To conclude: Differentiated products are everywhere; and examples of monopolistic competition abound.
The theory of monopolistic competition describes many markets in the economy, yet offers little guidance to policymakers looking to improve the market’s allocation of resources.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

22. Summary
A monopolistically competitive market has many firms, differentiated products, and free entry.
Each firm in a monopolistically competitive market has excess capacity—it produces less than the quantity that minimizes ATC. Each firm charges a price above marginal cost.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

23. Summary
Monopolistic competition does not have all of the desirable welfare properties of perfect competition.
There is a deadweight loss caused by the markup of price over marginal cost.
Also, the number of firms (and thus varieties) can be too large or too small.
There is no clear way for policymakers to improve the market outcome.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

24. Summary
Product differentiation and markup pricing lead to the use of advertising and brand names.
Critics of advertising and brand names argue that firms use them to reduce competition and take advantage of consumer irrationality.
Defenders argue that firms use them to inform consumers and to compete more vigorously on price and product quality.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.