1. Lecture 14 Monopolistic competition
Microeconomics 1000
Lecture 14 Monopolistic competition

2. Key points
Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.
Monopolistic competition is competition among firms that sell differentiated products.
The desirability of outcomes in monopolistically competitive markets.
The debate over the effects of advertising.
The debate over the role of brand names.

3. Four Types of Market Structure
Number of Firms?
One
firm
Few
firms
Many
firms
Type of Products?
Differentiated
products
Identical
products •
Novels
Movies
Monopolistic
Competition
(Chapter 17)
Perfect •
Wheat
Milk
Competition
(Chapter 14) •
Tap water
Cable TV
Monopoly
(Chapter 15) •
Tennis balls
Crude oil
Oligopoly
(Chapter 16)
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4. Monopolistic Competition
Types of Imperfectly Competitive Markets
Monopolistic Competition
Many firms selling products that are similar but not identical.
Oligopoly
Only a few sellers, each offering a similar or identical product to the others.

5. Monopolistic Competition
Markets that have some features of competition and some features of monopoly.
Firms have monopoly power in the short run; they produce different varieties of the same good but because product are differentiated the elasticity of demand is not very large.
However, each firm demand depend on how many varieties are being offered, and hence on the number of active firms
In the long run, competition prevails

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

7. Monopolistic Competition
Many Sellers
There are many firms competing for the same group of customers.
Product examples include books, CDs, movies, computer games, restaurants, etc.
Product Differentiation
Each firm produces a product that is at least slightly different from those of other firms.
Each firm faces a downward-sloping demand curve.

8. Monopolistic Competition
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.

9. Short and long run
Economists often distinguish between the short and the long run
In the short run, certain variables are fixed which in the long run can be adjusted
For example, in the short run the number of active firms is given, whereas in the long run the process of entry and exit may lead to a change in the number of active firms

10. COMPETITION WITH DIFFERENTIATED PRODUCTS
The Monopolistically Competitive Firm in the Short Run
In the short run, the firm behaves as a monopolist
However, short-run positive 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.

11. Average and marginal costs and profit
With constant unit cost
profit = (price – unit cost) x quantity
We then distinguished between two notions of unit cost: average cost and marginal cost
Average cost determines the level of profit
profit = (price – average cost) x quantity
Marginal cost determines the change in profit
∆profit = (marginal revenue – marginal cost) x ∆ quantity

12. Figure 1 Monopolistic Competition in the Short Run
(a) Firm Makes Profit
Price MC
ATC
Demand MR
Profit-
maximizing
quantity
Price
Average
total cost
Profit
Quantity
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13. COMPETITION WITH DIFFERENTIATED PRODUCTS
On the other hand, 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.

14. Figure 1 Monopolistic Competitors in the Short Run
(b) Firm Makes Losses
Price MC
ATC
Losses
Loss-
minimizing
quantity
Average
total cost
Demand
Price MR
Quantity
Copyright©2003 Southwestern/Thomson Learning

15. The Long-Run Equilibrium
Depending on whether in the short run firms are making profits or losses, firms will enter and exit the market.
Entry or exit shifts the demand curve of each individual firm

16. Figure 2 Entry and exit shift the individual demand curve
Price
firms exit
Initial demand
firms enter
Quantity
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17. The long run equilibrium
Firms will enter and exit until economic profit vanish (that is, until each firm earns just the “normal” profit)

18. Figure 3 A Monopolistic Competitor in the Long Run
Price MC
ATC
Demand MR
Profit-maximizing
quantity P =
ATC
Quantity
Copyright©2003 Southwestern/Thomson Learning

19. 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.
Unlike in a monopoly with blockaded entry, price equals average total cost.
Free entry and exit drive economic profit to zero.

20. Monopolistic Competition
Two more properties of the monopolistic competition equilibrium—excess capacity and markup.

21. Excess Capacity
There is no excess capacity if firms produce 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.
Clearly, that would be inefficient if output was homogeneous; but remember, products are differentiated and consumers value product variety

22. Figure 4 Equilibrium v. efficient scale
(a) Monopolistically Competitive Equilibrium
(b) Efficient scale
Price
Price MC
ATC MC
ATC
Demand MR P
Quantity
produced
Efficient
scale
Efficient scale
Quantity
Quantity
Copyright©2003 Southwestern/Thomson Learning

23. Mark up
For a monopolistically competitive firm, as form a monopoly, 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.

24. Figure 5 Monopolistic versus Perfect Competition
(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

25. Monopolistic Competition and the Welfare of Society
There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.
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.

26. Monopolistic Competition and the Welfare of Society
Externalities of entry include:
product-variety externalities (positive).
business-stealing externalities (negative).
Either effect may prevail, so in equilibrium there may be either insufficient or excessive entry

27. Monopolistic Competition and the Welfare of Society
The product-variety externality:
Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.
The business-stealing externality:
Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.

28. ADVERTISING
When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product.

29. ADVERTISING
Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising.
Overall, about 2 percent of total revenue is spent on advertising (over £150 billion a year only in the US).

30. ADVERTISING
Critics of advertising argue that firms advertise in order to manipulate people’s tastes.
They also argue that advertising impedes competition by implying that products are more different than they truly are.

31. ADVERTISING
Defenders argue that advertising provides information to consumers
They also argue that advertising increases competition by offering a greater variety of products and prices.
The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.

32. Brand Names
Critics argue that brand names cause consumers to perceive differences that do not really exist.
Some economists argue that brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality.
providing information about quality.
giving firms incentive to maintain high quality.

33. Summary
A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry.
The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.

34. Summary
Monopolistic competition does not lead to the ideal solution (the efficient number of varieties and the efficient quantity of each variety).
There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost.
The number of firms can be too large or too small.

35. Summary
The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names.
Critics argue that firms use advertising and brand names to take advantage of consumer irrationality and to reduce competition.
Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.