Econ 201 Lecture 8.1a May 26, 2009 Monopolistic Competition

Econ 201
Lecture 8.1a
May 26, 2009
Monopolistic Competition
Part II
Characteristics of
Monopolistic Competition
• Similar to Perfect Competition
– There are many producers in a given market.
– There are few barriers to entry and exit
– No extensive economies of scale
• No dominant firm or firms
• Differs from Perfect Competition
– goods and services are heterogeneous
• Consumers have clearly defined preferences and sellers
attempt to differentiate their products from those of their
• means that producers have some degree of control over
• Monopolistic Competition
– Market Demand is downward sloping
• Result of product differentiation
– So is firm demand, but it is smaller and more
elastic than Market Demand
– Firm sets price like a monopolist, but with less
market power (more elastic)
• Faces competition (cross-price elasticity)
• Sets Price on the D curve where MR = MC
• Monopolistic Competitive firm
– Prices like a monopolist
• Chooses Qs @ MR = MC
• Price > MC
– However
• Price for MC will be less than Monopolist
– Closer to PC than M
• Qty Supplied for Monop Compet Industry >
– Closer to PC than M
• Monopolistic Competition
– Also resembles Perfect Competition
• No economies of scale + free/ entry & exit
– Market characterized by a many firms
– Will drive long term economic profits to 0
• Competitors produce “close” substitutes
– Even with product differentiation – firms have only limited
market (pricing) power (similar to “competitive fringe”)
– Differs from Perfect Competition
• Is not as efficient
– Does not operate at min of LRAC
– Allocatively inefficient (MV > MC)
• “Excess Capacity” (too many firms/too much capital)
• Does produce greater product variety
MC in the Short-Run
• Qs set where MR = MC
• Earns + economic profit (monopoly rent)
MC in the Long-run
SR economic profits -> promote entry by new firms
• Price will be “competed” down to LRAC
– So no economic profit in LR
– Firms will still not operate at min LRAC (unlike PC mkt)
– More entry (unstable equilibria) & DWLoss
Characteristics of MC Markets
• Departures from perfect competition
– Differences in cost
• Don’t operate at min of LRAC
• Each firm may operate at different SRAC
– Unstable equilibrium
• Short-run (+) economic profits -> induce entry (minimal barriers) ->
compete profits away
• As newer, efficient firms enter -> older, less efficient exit ->
“constructive” destruction (high rate of “turnover” like PC)
• In the long-run,
– Factors that differentiate products are duplicated by competing firms.
» drives price down and,
» monopolistically competitive firm will make zero economic profit
(i.e. a rate of return equal to the rate required to compensate debt
and equity holders for the risk of investing in the firm).
• Unlike in perfect competition, the monopolistically competitive firm
does not produce at the lowest attainable average total cost.
Examples of MC Markets
• restaurants, cereal, clothing, shoes and
service industries in large cities
Role of Advertising
• Basic Taxonomy of Advertising
– From an economist’s perspective
– 1) Informational
• Product quality, pricing, availability
– “good gas at a good price”
– 2) Persuasive
• Attempts to alter tastes and preferences with
subjective information
• No product or pricing info
• Critics of monopolistic competition
– fosters advertising and the creation of brand names.
• advertising induces customers into spending more on
products because of the name associated with them rather
than because of rational factors.
– Refuted by defenders of advertising
• (1) brand names can represent a guarantee of quality, and
• (2) advertising helps reduce the cost to consumers of
weighing the tradeoffs of numerous competing brands.
Should We Regulate MC Markets?
• Monopolistically competitive firms are
inefficient, however:
– usually the case that the costs of regulating
prices for every product that is sold in
monopolistic competition by far exceed the
• the government would have to regulate all firms
that sold heterogeneous products
– Consumers value variety, i.e., product