Chapter
15
Monopolistic Competition
Monopolistic competition is a type of imperfect competition such
that many producers sell products that are differentiated from one
another (e.g. by branding or quality) and hence are not perfect
substitutes.
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 -> not perfect substitutes
– Free entry and exit (like PC)
• Zero economic profit in the long run (like PC)
– Because of free entry
3
Product Differentiation = not all milk is the same
Figure 1
The four types of market structure
Economists who study industrial organization divide markets into four types:
monopoly, oligopoly, monopolistic competition, and perfect competition.
5
Figure
FIGURE 15.1 Characteristics of Different Market Organizations
Figure
Figure
Industry Characteristics
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
Eight
Twenty
Four Largest
Largest
Largest Number of
Industry Designation
Firms
Firms
Firms
Firms
Travel trailers and campers
38
45
58
733
Games, toys
39
48
63
732
Wood office furniture
34
43
56
546
Book printing
33
54
68
560
Curtains and draperies
17
25
38
1,778
Fresh or frozen seafood
14
24
48
529
Women’s dresses
18
23
48
528
Miscellaneous plastic
6
10
18
6,775
products
Figure
HHI = sum of squared market shares for all firms in the industry
Larger HHI -> more concentrated industry
Competition with Differentiated Products
• Monopolistically competitive firm in short run
• Profit maximization –
– Uses similar profit-max rule as Monopoly/Oligopoly
• Faces downward sloping demand curve
• Needs to account for price ↓ as Q↑
– Chooses Output (Q): marginal revenue (Q) = marginal
cost (Q)
• Price determined by customer’s WTP for choosen output
(demand curve)
– If P > ATC: profit
– If P < ATC: loss
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Price and Output Determination in Monopolistic Competition
Product Differentiation and Demand Elasticity
FIGURE 15.2 Product Differentiation Reduces the Elasticity of Demand Facing a Firm
Monopolistic competitor less elastic than the demand curve that a perfectly competitive
firm faces.
Demand is more elastic than the demand curve for a because of close substitutes
Figure 2
Monopolistic competitors in the short run
(a) Firm makes profit
(b) Firm makes losses
Price
Price
MC
ATC
Price
MC
ATC
ATC
Price
ATC
Profit
Demand
Losses
Demand
MR
MR
0
Profitmaximizing
quantity
Quantity
0
Lossminimizing
quantity
Quantity
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.
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Competition with Differentiated Products
• The long run equilibrium
• If MC firms are making profit in short run
– New firms - incentive to enter the market
• No barriers to entry
– Increase number of products
• Increases number of closer substitutes
• Flattens firm’s demand curve
– Reduces demand faced by each firm
• Demand curve shifts left
– Each firm’s profit – declines until: zero
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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
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Figure 3
A monopolistic competitor in the long run
Price
ATC
MC
Price = ATC
MR
0
Profit- maximizing
quantity
Demand
Quantity
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
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firm earns zero profit.
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 (but not at min ATC)
• Price still exceeds marginal cost
– Even in LR
– Deadweight Loss
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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
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Figure 4
Monopolistic versus perfect competition
(a) Monopolistically Competitive Firm
(b) Perfectly Competitive Firm
Price
Price
MC
MC
ATC
ATC
Price
P=MC
P=MR
(demand curve)
Markup
MC
Demand
MR
0
Quantity
produced
Efficient
scale
Quantity
0
Quantity produced
= Efficient scale
Quantity
Excess capacity
Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the longrun 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,
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but price is above marginal cost under monopolistic competition.
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
21
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
22
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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Advertising and the price of
eyeglasses
• 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
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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 names
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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
1
Monopolistic competition: between perfect competition& monopoly
Market structure
Features that all three market
structures share
Goal of firms
Rule for maximizing
Can earn economic profits in the
short run?
Features that monopolistic
competition shares with monopoly
Price taker?
Price
Produces welfare-maximizing level of
output?
Features that monopolistic
competition shares with competition
Number of firms
Entry in long run?
Can earn economic profits in long
run?
Perfect
competition
Monopolistic
competition
Monopoly
Maximize profits
MR = MC
Maximize profits
MR = MC
Maximize profits
MR = MC
Yes
Yes
Yes
Yes
P = MC
No
P > MC
No
P > MC
Yes
No
No
Many
Yes
Many
Yes
One
No
No
No
Yes
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