MONOPOLISTIC COMPETITION

Main Questions
1. What market structures lie between perfect
competition and monopoly, and what are their
characteristics?
2. How do monopolistically competitive firms choose
price and quantity? Do they earn economic profit?
3. In what ways does monopolistic competition affect
society’s welfare?
4. What are the social costs and benefits of advertising?

LÂM MẠNH HÀ 2

Monopolistic Competition
• Imperfect competition
– Between perfect competition and monopoly
• Oligopoly
• Monopolistic competition
• Oligopoly
– Few sellers offer similar or identical products

LÂM MẠNH HÀ 3

1
 Monopolistic Competition
• Monopolistic competition
– Many sellers
– Product differentiation
→ Sellers are not price takers
→ Demand curve is downward sloping
– Free entry and exit
→ Each firm earns zero economic profit in the long
run

LÂM MẠNH HÀ 4

The Four Types of Market Structure

LÂM MẠNH HÀ 5

Short Run Equilibrium

• Profit maximization
– Firm produces the quantity where
• Marginal revenue MR  Marginal cost MC
– Price is determined on the demand curve
– Comparison between price and average total cost
• If P  ATC → firm makes a profit
• If P  ATC → firm gets losses
– Similar to monopoly

LÂM MẠNH HÀ 6

2
 Monopolistic Competitors
in the Short Run
(a) Firm makes profit (b) Firm makes losses
Price, cost/unit Price, cost/unit

(MC) (MC) (ATC)

Profit
(ATC) ATC
P
P
ATC (D)
MR  MC Losses
MR  MC (D)
(MR)
(MR)

Profit-maximizing Quantity Loss-minimizing Quantity

quantity quantity

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.

LÂM MẠNH HÀ 7

Long Run Equilibrium

• If firms are making profit in short run
– New firms have incentive to enter the market
– Increase in the number of products
→ Supply curve shifts right
– Decrease in demand faced by each firm
→ Demand curve shifts left
– Each firm’s profit declines until zero economic profit

LÂM MẠNH HÀ 8

A Monopolistic Competitor
in the Long Run

Price, cost/unit
(LRMC) (LRATC)

P  LRATC

MR  LRMC

(D)
(MR)

Profit-maximizing Quantity
quantity

In the long-run equilibrium, price equals average total cost, and the firm earns zero profit.

LÂM MẠNH HÀ 9

3
 Long Run Equilibrium
• Zero economic profit
– Demand curve
• touches the ATC curve at the quantity where
MR  LRMC
– At the point of tangency between the demand and
ATC curves
• P  LRATC
• P  LRMC

LÂM MẠNH HÀ 10

Long Run Equilibrium

• Monopolistic versus perfect competition
– Monopolistic competition
• Quantity in the long run is not determined at LRATCmin

→ Quantity produced  Efficient scale

→ excess capacity
• P  LRMC, markup over marginal cost.

– Perfect competition
• Quantity in the long run is determined at LRATCmin

→ Quantity produced  Efficient scale

• P  LRMC
LÂM MẠNH HÀ 11

Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
Cost/unit (LRATC) Cost/unit (LRATC) (LRMC)
(LRMC)

P
P LRMC  MR
Markup
(d) ≡ (MR)

(D)
LRMC  MR

(MR)

Quantity Efficient Quantity Quantity produced

produced scale  Efficient scale

Excess capacity

Panel (a) shows the long-run equilibrium in a monopolistically competitive market.

Panel (b) shows the long-run equilibrium in a perfectly competitive market.
LÂM MẠNH HÀ 12

4
 Welfare of Society
• Sources of inefficiency
– Markup of price over marginal cost
→ Deadweight loss of monopoly pricing
– Too much or too little entry
• Product-variety externality
– Because consumers get some consumer surplus from
the introduction of a new product, the entry of a new
firm confers (give) a positive externality on consumers.
• Business-stealing externality
– Because other firms lose customers and profits when
faced with a new competitor, the entry of a new firm
imposes a negative externality on existing firms.

LÂM MẠNH HÀ 13

Advertising
• Incentive to advertise
– When firms sell differentiated products and charge
prices above marginal cost, each firm has an incentive
to advertise to attract more buyers.
• Advertising spending
– Highly differentiated goods : 10-20% of revenue
– Industrial products : Little advertising
– Homogenous products : No advertising
– For the economy as a whole : about 2% of total
firm revenue is spent on advertising
LÂM MẠNH HÀ 14

Advertising
• Debate over advertising
– Wasting resources?
– Valuable purpose?

LÂM MẠNH HÀ 15

5
 The Critique of Advertising
• Firms advertise to
– manipulate (control in a dishonest way) people’s tastes
• Psychological rather than informational

• Firms creates a desire that otherwise might not exist

– impede (stop the progress) competition
– increase perception of product differentiation
• Firms foster (encourage) brand loyalty
– make buyers less concerned with price differences
among similar goods

LÂM MẠNH HÀ 16

The Defense of Advertising

• Advertising
– provides information to customers
→ allows customers to make better choices
→ enhances the ability of markets to allocate
resources efficiently
– fosters competition
→ customers can more easily take advantage of price
differences
– allows new firms to enter more easily

LÂM MẠNH HÀ 17

Advertising
• Advertising − a signal of quality
– The willingness of the firm to spend a large amount
of money on advertising can itself be a signal to
consumers about the quality of the product being
offered
– Content of advertising may be different from the truth
→ irrelevant

LÂM MẠNH HÀ 18

6
 Advertising
• Brand names
– spend more on advertising and charge higher prices than
generic substitutes
• Critics: brand names
– cause consumers to perceive differences that do not really
exist
• Consumers’ willingness to pay more for the brand name
good is a form of irrationality fostered by advertising
• Defenders: brand names
– provide consumers with information about quality
– give firms an incentive to maintain high quality
LÂM MẠNH HÀ 19

Monopolistic Competition:
Between Perfect Competition
and Monopoly

LÂM MẠNH HÀ 20

CHAPTER SUMMARY
1. A monopolistically competitive market has
many firms, differentiated products, and free entry.
2. Each firm in a monopolistically competitive market has
excess capacity – produces less than the quantity that
minimizes ATC.
3. Each firm charges a price above marginal cost.

21

7
 CHAPTER SUMMARY
4. Monopolistic competition does not have all of the
desirable welfare properties of perfect competition.
• There is a deadweight loss caused by the markup of
price over marginal cost.
• Also, the number of firms (and thus varieties) can
be too large or too small.
• There is no clear way for policymakers to improve
the market outcome.

22

CHAPTER SUMMARY
5. Product differentiation and markup pricing lead to the
use of advertising and brand names.
• Critics of advertising and brand names argue that
firms use them to reduce competition and take
advantage of consumer irrationality.
• Defenders argue that firms use them to inform
consumers and to compete more vigorously on
price and product quality.

LÂM MẠNH HÀ 23