Monopolistic

Competition

Chapter 17
The Four Types of Market Structure
Number of Firms?

Type of Products?

One firm Few firms Many firms

Differentiated Identical
products products

Monopoly Oligopoly Monopolistic Perfect

Competition Competition
• Tap water
(Maynilad, • Tennis balls • Cellphones • Wheat
Manila Water) • Crude oil, • Branded • Milk
• Telephone processed oil Clothes
• Rice
• Search Engine
 Types of Imperfectly Competitive
Markets

 Monopolistic Competition
 Many firms/sellers, selling products that
are similar but not identical
 Brands compete on other qualities
 Oligopoly
 Only a few sellers, each offering a similar
or identical product to the others.
Monopolistic Competition

Markets that have some

features of competition
and some features of
monopoly.
 Attributes of Monopolistic
Competition

 Many sellers
 Product differentiation
 Whatmakes your product
UNIQUE
 Free entry and exit
 Many Sellers
1. There are many firms/sellers
competing for the same group of
customers.
2. Product examples include books,
music, movies, computer games,
restaurants, piano lessons, swimming
lessons, furniture, etc.
 Product Differentiation
 Each firm/seller produces a product
that is at least slightly different
from those of other firms.
 Rather than being a price taker
(horizontal demand curve), each
firm/seller faces a downward-
sloping demand curve (the seller
can control the quantity sold in
response to the selling price)
 Free Entry or Exit
 Firms can enter or exit the market
without restriction.
 Zero or cheap entry and exit costs.
 Firms/sellers enter and exit until
economic profits are zero.
 Zero economic profits does not
mean zero profit (in the accounting
sense)
 It means no more ‘big’ accounting
profit typical in a monopoly
 Monopolistic Competitors in the
Short Run...

(a) Firm Makes a Profit

Price
MC
ATC

Price
Average
total cost Demand
Profit
MR

0 Profit-
Quantity
maximizing quantity
Monopolistic Competitors in the
Short Run...
(b) Firm Makes Losses
ATC
MC
Price
Losses

Average
total cost
Price

Demand
MR

0 Loss- Quantity
minimizing
quantity
 Monopolistic Competition in the
Long Run
Short-run economic profits encourage new
firms to enter the market in the long run.
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.
 Monopolistic Competition in the
Long Run
Short-run economic losses encourage
firms to exit the market in the long run.
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.
The Long-Run Equilibrium

Firms will enter and exit

until the firms are making
exactly zero economic
profits.
 A Monopolistic Competitor
in the Long Run...
Price
MC
ATC

P=ATC

Demand
MR
0
Profit-maximizing Quantity
quantity
 Two Characteristics of Long-Run
Equilibrium

 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.
Two Characteristics of Long-Run
Equilibrium
 As
in a competitive market, price
equals average total cost.
 Freeentry and exit drive economic
profit to zero.
 Monopolistic versus Perfect
Competition

There are two noteworthy

differences between
monopolistic and perfect
competition—excess capacity
and markup.
 Excess Capacity

 There is no excess capacity in

perfect competition in the long
run.
 Free entry results in competitive
firms producing at the point
where average total cost is
minimized, which is the efficient
scale of the firm.
 Excess Capacity

 There is excess capacity in

monopolistic competition in the
long run.
 In monopolistic competition,
output is less than the efficient
scale of perfect competition.
 Excess Capacity...

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
ATC ATC

P
P = MC P = MR
Excess capacity (demand
curve)
Demand

Quantity Quantity
Quantity Efficient Quantity= Efficient
produced scale produced scale
 Markup Over Marginal Cost

 For a competitive firm, selling

price equals marginal cost (P =
MC)
 For a monopolistically
competitive firm, selling price
exceeds marginal cost (P > MC)
Markup Over Marginal Cost

Because price exceeds

marginal cost, an extra unit
sold at the posted price
means more profit for the
monopolistically competitive
firm.
 Markup Over Marginal
Cost...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
Markup MC MC
ATC ATC

P
P = MC
P = MR
(demand
Marginal curve)
cost
MR Demand

Quantity Quantity
Quantity Quantity
produced produced
 Monopolistic versus Perfect
Competition...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
Markup ATC ATC

P
P = MC P = MR
Marginal (demand
cost curve)

MR Demand

Quantity Efficient Quantity Quantity produced = Quantity

produced scale Efficient scale
Excess capacity
Monopolistic Competition and the
Welfare of Society

Monopolistic competition does

not have all the desirable
properties of perfect
competition.
 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.
 However, the administrative burden
of regulating the pricing of all firms
that produce differentiated products
would be overwhelming.
Monopolistic Competition and the
Welfare of Society
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 many or too few firms in the market
Monopolistic Competition and the
Welfare of Society

Externalities of entry include:

 product-variety externalities.
 business-stealing externalities.
 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.
 Monopolistic Competition and the
Welfare of Society

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.
 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.
 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, or over $100 billion a
year, is spent on advertising.
 Advertising

 Critics of advertising argue that firms

advertise in order to manipulate
people’s tastes.
 They also argue that it impedes
competition by implying that
products are more different than they
truly are.
 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.
 Brand Names
 Criticsargue that brand names cause
consumers to perceive differences
that do not really exist and
 Brand names charge a premium for
‘better’ quality that is not really there.
 Brand Names

 Economists have argued 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 (firms want to protect their
reputation)
 Summary
A monopolistically competitive market
is characterized by three attributes:
many firms, differentiated products,
and free entry of firms/sellers.
 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.
 Summary

 Monopolistic competition does not

have all of the desirable properties
of perfect competition.
 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.
 Summary

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