CHAPTER
11
Entry and Monopolistic
Competition
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
The Effects of Market Entry


In the absence of substantial economies of
scale, it is possible for additional firms to enter
the market, driving down prices and profit.
Output decisions are based on the marginal principle:
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost, but reduce the level if the
marginal cost exceeds the marginal benefit. If
possible, pick the level at which the marginal benefit
equals the marginal cost.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of Market Entry

When a second firm
enters the market,
the monopoly’s
demand and
marginal revenue
curves shift inward.

The firm’s price and
output level will have
to be adjusted in
order to follow the
marginal principle.
3
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of Market Entry


© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
Given the structures
of cost and revenue,
the monopoly
satisfies the
marginal principle
by producing and
selling 300
toothbrushes at $2
each.
After entry, each of
two firms produces
200 units and
charges $1.85 per
4
unit.
O’Sullivan & Sheffrin
The Effects of Market Entry


Before entry, the
monopoly produces
300 units, at a cost
per unit of $0.90
per toothbrush.
After entry, each of
two firms produces
200 units at an
average cost of
$1.00.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of Market Entry
Summary:

There are three
reasons why profit
decreases for the
individual firm after
entry of a second
firm:

Lower price

Lower quantity sold

Higher average
cost of production
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Characteristics of Monopolistic
Competition
Characteristics of Monopolistic
Competition:

Many firms

Differentiated product

No artificial barriers to entry
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Meaning of “Monopolistic
Competition”
Each firm is monopolistic because it
sells a unique product.
 Each firm is a competitive because it
sells a product that is a close but not a
perfect substitute for the products sold
by other firms in the market.


The availability of close substitutes makes
the firm’s demand very price elastic.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Product Differentiation
Firms may differentiate their product in
several ways:

Physical characteristics

Location

Services

Aura or image
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Short-run and Long-run Equilibrium
Under Monopolistic Competition



As long as there is profit to be made, more and more
firms will enter the market.
As firms enter, each firm’s demand curve shifts to the
left, decreasing market price, decreasing the quantity
produced per firm, and increasing the average cost of
production.
Entry will stop once the economic profit of each existing
firm reaches zero. In the long run, revenue will be just
enough to cover all costs, including the opportunity cost
of all inputs, but not enough to cause additional firms to
enter.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Long-run Equilibrium Under
Monopolistic Competition

In this example, the
marginal principle is
satisfied at 55
thousand toothbrushes
per minute, selling at a
price of $1.35. The
cost of producing each
toothbrush is also
$1.35. Economic profit
equals zero.
11
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Trade-offs with Monopolistic
Competition
Monopoly
Monopolistic Competition
12
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Trade-offs with Monopolistic
Competition
Monopolistic competition brings good
news and bad news relative to the
monopoly outcome:

Good news: lower price and greater
variety

Bad news: higher average cost
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spatial Differentiation and Competition


There are many spatially differentiated products.
When firms differentiate their products by offering
them at more locations, the benefit of having more
firms is that consumers travel shorter distances to
get the product.
With a single seller, the average cost of production
would be lower, but prices would be higher, and
consumers would spend more time traveling to buy the
product.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin