1. Monopolistic Competition
Chapter 25:
Monopolistic Competition

2. CHARACTERISTICS Relatively Large Number of Sellers Small Market Shares
No Collusion
(collusion needs few producers)
Independent Action
(each firm sets its price without considering the possibility of rival reactions)
2) Differentiated Products
Product Attributes, Service, Location (accessibility),
Brand Names and Packaging, Some Control Over Price
3) Role of Advertising
To differentiate their products (Non-price competition)
4) Easy Entry and Exit (relative to monopoly)
Relatively small, don’t heavily rely on economies of scale.

3. Price and Output in Monopolistic Competition
The firm’s demand curve
The firm faces a highly, but not perfectly, elastic demand curve.
Reasons:
The seller has many competitors.
Close substitutes to its product.
Elasticity of demand for the producer depends on:
The number of rivals (+)
The degree of product differentiation (-)

4. Optimal Output: The Short Run
Rule: MC = MR
There are tow possibilities:
Profit
Losses
Optimal Output: The long run:
Only a Normal Profit (i.e. economic profit = zero)

5. Profits: Firms enter.
In the short run economic profits attract new entrants.
Demand facing the firm shifts to the left
Profits decline
Demand curve is tangent to ATC
No further incentive for entry

6. Losses: Firms leave
In the short run economic losses force some firms to leave
Demand facing the firm shifts to the right
losses disappear
Demand curve is tangent to ATC
No further incentive to exit

7. PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Economic ProfitsMC
ATC P1 A1
Price and Costs
Economic
Profits D
New competition drives down the
price level – leading to economic
losses in the short run MR Q1
Quantity

8. PRICE AND OUTPUT IN MONOPOLISTIC COMPETITIONMC
ATC A2 P2
Economic
Losses
Price and Costs D MR
With economic losses, firms will
exit the market – Stability occurs
when economic profits are zero Q2
Quantity

9. MONOPOLISTIC COMPETITION
PRICE AND OUTPUT IN
MONOPOLISTIC COMPETITION MC
Long-Run Equilibrium
Normal
Profit
Only
ATC P3
= A3
Price and Costs D MR Q3
Quantity

10. MONOPOLISTIC COMPETITION AND EFFICIENCY
In Pure Competition only
Economic Efficiency: P = MC = Minimum ATC
Productive Efficiency: P = ATC
Goods are produced in the least costly way.
Price is just efficient to cover total costs including a normal profit
Allocative Efficiency: P = MC
The right amount of output is being produced.
The right amount of the society’s scarce resources is being devoted to this specific use.

11. MONOPOLISTIC COMPETITION
AND EFFICIENCY
In Monopolistic Competition
Not Productively Efficient:
price  Minimum ATC
P > Minimum ATC
Not Allocatively Efficient:
Price  MC

12. Monopolistic competition results in underallocation of the society’s resources.
Monopolistic competition is not allocatively efficient.
Consumers pay a higher than the competitive price and obtain a less than optimal output.
Monopolistic competition producers must charge a higher than the competitive price in the long run in order to achieve a normal profit.
The price-marginal cost gap experienced by each firm creates an industrywide efficiency loss.

13. Excess Capacity Optimal capacity is to produce at minimum ATC.
The gap between minimum ATC and the profit maximizing price identifies excess capacity:
Plant and equipment are underused because production is at less than minimum ATC.

14. MONOPOLISTIC COMPETITION
AND EFFICIENCY MC
Long-Run Equilibrium
Price is Not
= Minmum
ATC
ATC P3
= A3
Price  MC
Price and Costs D MR
Excess capacity Q3 Q4
Quantity