1. Introduction to Monopolistic Competition
Micro:
Econ: 31 67
Module
Introduction to Monopolistic Competition
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

2. What you will learn in this Module:
How are prices determined in monopolistic competition?
Can you show the short and long run outcomes?
How can monopolistic competition lead to inefficiency and excess capacity?
The purpose of this module is to introduce the monopolistic competition market structure. The short-run and long-run outcomes are presented and compared to the efficiencies found in perfect competition.

3. Monopolistic Competition
Characteristics in common with PC:
Many firms exist in the market, but not as many as perfect competition.
Little opportunity for tacit collusion
There are no barriers to entry or exit.
Characteristics in common with monopoly:
Each firm has some ability to set the price of their product, largely due to product differentiation.
This market structure shares characteristics with both perfect competition and monopoly.
Unlike oligopoly, there is little opportunity for tacit collusion as there are too many firms in the industry for it to be successful. The only real opportunity for strategic behavior is to advertise to consumers the message that their differentiated product is better than the similar, but different, rival products.
A good example of monopolistic competition is the local market for restaurants, retail groceries or clothing stores.

4. Monopolistic Competition in the Short Run
In the short run, monopolistic competitors set price and quantity in the same way a monopoly does.
Monopolistic competitors can earn a profit in the short run.
Because firms have a differentiated product, the demand for their product is downward sloping.
The firm maximizes profit the same way all of the other firms do: by finding Q* where MR=MC. The price P* is found by going vertically to the demand curve. The rectangle of profit is found by locating ATC at the output Q*.
The firm here is earning positive economic profit because P*>ATC.

5. Monopolistic Competition in the Short Run
ATC
Monopolistic competitors can also earn a loss in the short run.
Dojo: what two conditions can cause loss?
However positive profits are not guaranteed. If demand is too weak, or if costs are too high, losses could be incurred in the short run.
The firm here is incurring economic losses because P*<ATC.

6. Monopolistic competition in the Long Run
Entry and exit occur in response to short-run profits or losses
In the long run, Monopolistic competitors earn a normal profit  why?
What happens to a profit-making firm when other entrepreneurs see that economic profits are being made?
-Short-run profits attract entry into the market.
-Demand and marginal revenue for existing firms’ products declines (shifts to the left), as there are more similar products available to the same number of consumers.
-A weaker demand causes prices to fall. Lower prices cause economic profits to fall (the profit rectangle is getting smaller).
-Entry stops when normal profits are made (firms are breaking even).
What happens to a firm when losses are being incurred?
-Short-run losses prompt exit from the market.
-Demand and marginal revenue for remaining firms’ products rises (shifts to the right), as there are fewer similar products available to the same number of consumers.
-A stronger demand causes prices to rise.
-Higher prices cause economic losses to fall (the rectangle of losses is getting smaller).
What does this mean?
The only way for firms to break even (earn a normal profit) is for P*=ATC so there is no profit or loss rectangle.
Since price comes from the demand curve, the only way for P*=ATC is for the demand curve to touch ATC at the output Q*, where MR=MC.
In our graph, the only place where this happens is where the downward-sloping demand curve is just tangent to the U-shaped ATC curve at the output Q*.
Because there are only normal profits being made, firms will neither enter nor exit this market and long-run equilibrium is achieved.

7. Comparing Monopolistic Competition with Perfect Competition
Economic profit = 0 (normal profit), so ATC=P in both due to entry and exit
MR = MC in both (profit maximization rule)
In perfect competition, minATC = P = MR = MC
In monopolistic competition ATC = P > MR = MC
Perfect competition achieves productive efficiency by producing at the minimum ATC
Monopolistic competition results in excess capacity
Recall what we learned when studying perfect competition.
The long-run level of output is where P=MR=MC=ATC.
Economic profits are zero; a normal profit is earned.
In monopolistic competition, we have learned that:
The long-run level of output is where P=ATC>MR=MC.
So while profits are zero in both market structures, the clear difference is that in monopolistic competition P>MC.
A more subtle difference exists in exactly where on the ATC curve is P=ATC.
In perfect competition, P=ATC at the minimum of the ATC curve. The level of output being produced is the one that corresponds to the lowest ATC.
In monopolistic competition, P=ATC on the downward sloping range of the ATC curve. This level of output is smaller than the one that minimizes ATC. Economists call this excess capacity.
So we can add another difference, referred to as excess capacity, between the two market structures.
In monopolistic competition, firms do not produce the level of output at which ATC is minimized.
By extension, the entire industry does not produce these products at the lowest possible cost.

8. Is Monopolistic Competition Inefficient?
Yes, P > MC so there is DWL
If P =/= MC some the market is inefficient in some way.
BUT, variety (differentiated products) provides a benefit to consumers.
We might call this DWL “the cost of variety”
In the Monopoly module, we saw that deadweight loss exists when output stops prior to the point where P=MC. In fact, anytime price is not equal to marginal cost, efficiency can be improved.
In monopolistic competition, P>MC so deadweight loss exists, and inefficiency exists. Because there is more competition for consumers, the wedge between price and marginal cost is lower in this market structure than it was in monopoly, so the degree of DWL is smaller in monopolistic competition.
Can we live with some DWL?
Probably. After all, the reason why P>MC is because firms have differentiated products that allows them some degree of pricing power similar to, but not as significant as, a monopolist.
This DWL might be called the “price of variety”. The monopolistically competitive restaurant industry is much preferred (though inefficient) to the perfectly competitive version where all menus are the same.

9. Food bar, or bars of food? Option 1 – consumers choose what to eat.
World Health Organization – China = 33.4% income on average across country
Option 2 – government controlled perfectly competitive market – produce a nutritious and filling bar of food for next to nothing.
In the Monopoly module, we saw that deadweight loss exists when output stops prior to the point where P=MC. In fact, anytime price is not equal to marginal cost, efficiency can be improved.
In monopolistic competition, P>MC so deadweight loss exists, and inefficiency exists. Because there is more competition for consumers, the wedge between price and marginal cost is lower in this market structure than it was in monopoly, so the degree of DWL is smaller in monopolistic competition.
Can we live with some DWL?
Probably. After all, the reason why P>MC is because firms have differentiated products that allows them some degree of pricing power similar to, but not as significant as, a monopolist.
This DWL might be called the “price of variety”. The monopolistically competitive restaurant industry is much preferred (though inefficient) to the perfectly competitive version where all menus are the same.