Monopolistic Competition
or …
An economic view of the wide world
between Perfect Competition and Pure
Monopoly
Monopolistic Competition
The study of which will help us answer one of
life’s great mysteries.
Why in the world do we have so many:
 Fast food places
 Gas stations
 Coffee shops
 Clothing retailers … ?
Monopolistic Competition
Characteristics:
 Numerous participants
 Freedom of exit and entry
 Perfect information
 Heterogeneous (or differentiated) products
Sound Familiar?
Which of the characteristics of Monopolistic
Competition match those of Perfect
Competition?
Characteristics

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Numerous participants
Freedom of entry and exit
Perfect information
Heterogeneous (or differentiated) products
 Perfect
Competition assumes all products from different
firms are identical
 Under Monopolistic Competition each seller’s product is
perceived by the buyer as somewhat different from the
products of other sellers
How are Products Differentiated?

Fast Food
 Location
 Product
“quality”
 Brand image

Coffee Shops
 Location/convenience
 Product
taste/quality
 Store atmosphere
Note Regarding Product
Differentiation

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Buyer’s perception of difference is what is
important – the “reality” of the difference is
irrelevant
Reverse is also true – a “real” difference in
product quality or performance that is not
perceived or recognized by consumers is
irrelevant
What does this imply about the “value” of
advertising to producers and consumers?
Monopolistic vs. Perfect Competition

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Demand curve for a firm operating in a perfectly
competitive market is ____________.
Why?
If products are differentiated in a
monopolistically competitive market – what
does this imply about the shape of the demand
curve for a firm operating in a “MC” market?
MC Market Demand Curves

Demand curve for a firm in a monopolistically
competitive market slopes down

Product differentiation (think brand loyalty)
reduces the impact of price changes on
consumer behavior
MC Demand Curve vs. Monopoly
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Demand curve for a monopoly also slopes down
But, slope of the curve is steeper for a
monopoly vs. a firm operating in a
monopolistically competitive market
Why?
Fewer (or no) substitute products and little
choice for consumers translates into less buyer
reaction in response to price movements
Between Monopoly and PC
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In a monopolistically competitive market, brand
loyalty and product differentiation create small
(often localized) monopolies
But, these monopolistically competitive firms
face competitive pressure from many (imperfect)
substitute products
What does this imply about the ability of
monopolistic competitors to earn above market
economic returns?
What Have You Learned About
Economic Profit?

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Firms operating in perfectly competitive markets
maximize profit so that P = MC
Competitive pressures in the form of new
entrants push down prices until P = AC
In the long run, firms operating in perfectly
competitive markets cannot earn excess returns
(P = MC = AC)
Graph
Other Fun Facts About Economic
Returns
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Monopolies can maximize their profits by
producing to the point where marginal revenue
(MR) equals marginal cost (MC)
Without competitive pressure, monopolies can
earn excess returns (represented by D – AC)
over the long run
Graph
Back to Our Original Question

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Similar to monopolies, monopolistic
competitors maximize profit in the short run by
producing to the point where MC = MR (think
small, or local, monopolies)
This results in excess returns in the short run
Graph
But, There is Always the Long Run
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Similar to perfect competition, excess returns
attract new entrants to the market
(McDonalds/Wendy’s; Starbucks/Caribou;
Exxon/BP)
These might not be perfect substitutes in the
minds of every consumer, but these new
entrants will shift the demand curve downward
until long run equilibrium is achieved (P = AC)
Graph
Excess Capacity Theorem

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Note that D intersects AC at a point where
average costs were still declining (AC curve
sloping down)
Graph
Remember in a perfectly competitive market
equilibrium occurs at the low point on the AC
curve
This implies that in monopolistically competitive
markets: (1) unit costs are higher and (2) there is
excess capacity and greater inefficiency
Implications for Consumers
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If monopolistically competitive firms merge
costs would go down and efficiency would go
up (usually a good thing for consumers)
Examples
But, choices would be also be reduced (fewer
fast food and coffee shop choices)
Tradeoff between efficiency (lower costs) and
standardization
Summary
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Monopolistic competitors offer heterogeneous
products (as perceived by buyers)
Similar to monopolies, firms operating in
monopolistically competitive markets may realize
excess returns in the short run
In the long run new entrants will squeeze out excess
returns and drive prices down until P =AC
Theoretical inefficiency is probably not a bad tradeoff
given consumer preference for variety and choice