Chapter

Monopolistic Competition

15

Between Monopoly & Perfect Competition

• Imperfect competition– Between perfect competition and monopoly– Oligopoly– Monopolistic competition

• Oligopoly– Few sellers– Offer similar or identical products

2

Between Monopoly & Perfect Competition

• Monopolistic competition– Many sellers (like PC)– Product differentiation (no one else)

• Not price takers• Downward sloping demand curve

– Product differentiation gives them some market power

– Free entry and exit (like PC)• Zero economic profit in the long run (like PC)

– Because of free entry

3

Figure

The four types of market structure

1

4Economists who study industrial organization divide markets into four types: monopoly, oligopoly, monopolistic competition, and perfect competition.

Figure FIGURE 15.1 Characteristics of Different Market Organizations

Figure

monopolistic competition A common form of industry (market) structure characterized by a large number of firms, no barriers to entry, and product differentiation.

TABLE 15.1 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 2002

Industry DesignationFour Largest

Firms

Eight Largest Firms

Twenty Largest Firms

Number ofFirms

Travel trailers and campers 38 45 58 733Games, toys 39 48 63 732Wood office furniture 34 43 56 546Book printing 33 54 68 560Curtains and draperies 17 25 38 1,778Fresh or frozen seafood 14 24 48 529Women’s dresses 18 23 48 528Miscellaneous plastic products

6 10 18 6,775

Industry Characteristics

Competition with Differentiated Products

• Monopolistically competitive firm in short run• Profit maximization

– Quantity: marginal revenue = marginal cost– Price: on the demand curve– If P > ATC: profit– If P < ATC: loss

7

FIGURE 15.2 Product Differentiation Reduces the Elasticity of Demand Facing a Firm

The demand curve that a monopolistic competitor faces is likely to be less elastic than the demand curve that a perfectly competitive firm faces. Demand is more elastic than the demand curve that a monopolist faces because close substitutes for the products of a monopolistic competitor are available.

Price and Output Determination in Monopolistic Competition

Product Differentiation and Demand Elasticity

Figure

Monopolistic competitors in the short run

2

9

Price

Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal revenue equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is above average total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost.

Quantity 0

(a) Firm makes profit

Profit

MC

ATC

Profit-maximizing

quantity

ATC

(b) Firm makes losses

MR

Demand

Price

Price

Quantity 0

Losses

MC ATC

Loss-minimizing

quantity

ATC

MR

Demand

Price

Competition with Differentiated Products

• The long run equilibrium• If 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

– Each firm’s profit – declines until: zero economic profit

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Competition with Differentiated Products

• The long run equilibrium• If firms are making losses in short run

– Firms - incentive to exit the market– Decrease number of products– Increases demand faced by each firm

• Demand curve shifts right

– Each firm’s loss – declines until: zero economic profit

11

Figure

A monopolistic competitor in the long run

3

12

Price

In a monopolistically competitive market, if firms are making profit, new firms enter, and the demand curves for the incumbent firms shift to the left. Similarly, if firms are making losses, old firms exit, and the demand curves of the remaining firms shift to the right. Because of these shifts in demand, a monopolistically competitive firm eventually finds itself in the long-run equilibrium shown here. In this long-run equilibrium, price equals average total cost, and the firm earns zero profit.

Quantity 0

MC ATC

Profit- maximizingquantity

MRDemand

Price = ATC

Competition with Differentiated Products

• The long run equilibrium• Zero economic profit

– Demand curve• Tangent to average total cost curve• At quantity where marginal revenue = marginal

cost• Price = average total cost

• Price exceeds marginal cost

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Competition with Differentiated Products

• Monopolistic versus perfect competition, long run equilibrium– Monopolistic competition

• Quantity: not at minimum ATC– Excess capacity

• P > MC, markup over marginal cost

– Perfect competition• Quantity: at minimum ATC

– Efficient scale

• P = MC

14

Figure

Monopolistic versus perfect competition

4

15

Price

Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-run equilibrium in a perfectly competitive market. Two differences are notable. (1) The perfectly competitive firm produces at the efficient scale, where average total cost is minimized. By contrast, the monopolistically competitive firm produces at less than the efficient scale. (2) Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition.

Quantity 0

(a) Monopolistically Competitive Firm

MC

ATC

Quantityproduced

MC

(b) Perfectly Competitive Firm

MR

Demand

Price

Price

Quantity 0Efficientscale

Markup

MCATC

Quantity produced = Efficient scale

P=MR (demand curve)

P=MC

Excess capacity

Competition with Differentiated Products

• Monopolistic competition & society’s welfare • Sources of inefficiency

– Markup of price over marginal cost• Deadweight loss

– Too much or too little entry• Product-variety externality

– Positive externality on consumers

• Business-stealing externality– Negative externality on producers

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Advertising

• When firms– Sell differentiated products– At price above marginal cost

• Then, they have incentive to advertise – To attract more buyers

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Advertising

• Debate over advertising• The critique of advertising

– Firms advertise to manipulate people’s tastes• Psychological rather than informational• Creates a desire that otherwise might not exist

– Impedes competition– Increase perception of product differentiation

• Foster brand loyalty

– Makes buyers less concerned with price differences among similar goods

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Advertising

• Debate over advertising• The defense of advertising

– Provide information to customers• Customers - make better choices• Enhances the ability of markets to allocate

resources efficiently

– Fosters competition• Customers - take advantage of price differences

– Allows new firms to enter more easily

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• What effect does advertising have on the price of a good?– Consumers – view products as being more different

than they otherwise would• Markets less competitive• Firms’ demand curves less elastic• Higher prices

– Consumers – easier to find firms with the best prices• Markets – more competitive• Firms’ demand curves more elastic• Lower prices

Advertising and the price of eyeglasses

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• 1963, Test: advertising by optometrists• States that prohibited advertising

– Average price paid for a pair of eyeglasses = $33

• States that did not restrict advertising– Average price = $26

• Advertising– Reduced average prices– Fosters competition

Advertising and the price of eyeglasses

21

Advertising

• Advertising as a signal of quality • Advertising – 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

22

Advertising

• Brand names• Firm – brand name

– Spend more on advertising– Charge higher prices– Than generic substitutes

• Critics of brand names– Products – not differentiated– Irrationality: consumers are willing to pay more

for brand names23

Advertising

• Brand names• Defenders of brand names

– Useful: high quality• Consumers – information about quality• Firms – incentive to maintain high quality

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Table

Monopolistic competition: between perfect competition& monopoly

1

25

Market structure

Perfectcompetition

Monopolisticcompetition Monopoly

Features that all three market structures shareGoal of firms Rule for maximizing Can earn economic profits in the short run? Features that monopolistic competition shares with monopolyPrice taker? PriceProduces welfare-maximizing level of output? Features that monopolistic competition shares with competitionNumber of firms Entry in long run? Can earn economic profits in long run?

Maximize profits MR = MC

Yes

Yes P = MC

Yes

ManyYes

No

Maximize profits MR = MC

Yes

No P > MC

No

ManyYes

No

Maximize profits MR = MC

Yes

No P > MC

No

One No

Yes