Chapter 16

Monopolistic Competition
Micro Economics
(IMR0227A)
In chapter 16,
look for the answers to these questions:
 What market structures lie between perfect
competition and monopoly, and what are their
characteristics?
 How do monopolistically competitive firms choose
price and quantity? Do they earn economic profit?
 In what ways does monopolistic competition affect
society’s welfare?
 What are the social costs and benefits of
advertising?
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 Introduction:
Between Monopoly and Competition
Two extremes
 Perfect competition: many firms, identical
products
 Monopoly: one firm
In between these extremes: imperfect competition
 Oligopoly: only a few sellers offer similar or
identical products.
 Monopolistic competition: many firms sell
similar but not identical products.

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The Four Types of
Market Structure

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 Characteristics & Examples
of Monopolistic Competition
Characteristics:
 Many sellers
 Product differentiation
 Free entry and exit
Examples:
 apartments
 books
 bottled water
 clothing
 fast food
 night clubs
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 Comparing Perfect & Monop. Competition
Perfect Monopolistic
competition competition

number of sellers many many

free entry/exit yes yes

long-run econ. profits zero zero

the products firms sell identical differentiated

firm has market power? none, price-taker yes

downward-
D curve facing firm horizontal
sloping

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Comparing Monopoly & Monop. Competition
Monopolistic
Monopoly
competition
number of sellers one many

free entry/exit no yes

long-run econ. profits positive zero

firm has market power? yes yes

downward-
downward-
D curve facing firm sloping
sloping
(market demand)
close substitutes none many
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 A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve. Price
profit MC
At each Q, MR < P. P ATC
To maximize profit, ATC
firm produces Q D
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

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 A Monopolistically Competitive Firm
With Losses in the Short Run
For this firm,
P < ATC
Price
at the output where MC
MR = MC.
losses ATC
The best this firm ATC
can do is to
P
minimize its losses.
D
MR
Q Quantity

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Monopolistic Competition and Monopoly
 Short run: Under monopolistic competition,
firm behavior is very similar to monopoly.
 Long run: In monopolistic competition,
entry and exit drive economic profit to zero.
 If profits in the short run:
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
 If losses in the short run:
Some firms exit the market,
remaining firms enjoy higher demand and prices.
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A Monopolistic Competitor in the Long Run
 Entry and exit
occurs until
P = ATC and Price
profit = zero. MC
 Notice that the ATC
firm charges a P = ATC
markup of price
over marginal markup
cost and does D
not produce at MC MR
minimum ATC.
Q Quantity

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Monopolistic Competition
V.S. Perfect Competition

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 Why Monopolistic Competition Is
Less Efficient than Perfect Competition
1. Excess capacity
 The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
 Under perfect competition, firms produce the
quantity that minimizes ATC.

2. Markup over marginal cost

 Under monopolistic competition, P > MC.
 Under perfect competition, P = MC.

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END
 Chapter 16
Monopolistic Competition
Micro Economics
(IMR0227A)
 Monopolistic Competition and Welfare
 Monopolistically competitive markets do NOT
have all the desirable welfare properties of
perfectly competitive markets.
 Because P > MC, the market quantity is below
the socially efficient quantity.
 Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
to reduce prices.

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 Monopolistic Competition and Welfare
 Number of firms in the market may not be optimal,
due to external effects from the entry of new firms:
 The product-variety externality:
surplus consumers get from the introduction
of new products
 The business-stealing externality:
losses incurred by existing firms
when new firms enter market
 The inefficiencies of monopolistic competition are
subtle and hard to measure. No easy way for
policymakers to improve the market outcome.

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ACTIVE LEARNING 1
Advertising
1. So far, we have studied three market
structures: perfect competition, monopoly, and
monopolistic competition. In each of these,
would you expect to see firms spending money
to advertise their products?
2. Is advertising good or bad from society’s
viewpoint? Try to think of at least one “pro”
and “con.”

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 Advertising
 In monopolistically competitive industries,
product differentiation and markup pricing
lead naturally to the use of advertising.
 In general, the more differentiated the products,
the more advertising firms buy.
 Economists disagree about the social value of
advertising.

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 The Critique of Advertising
 Critics of advertising believe:
 Society is wasting the resources it devotes to
advertising.
 Firms advertise to manipulate people’s tastes.
 Advertising impedes competition –
it creates the perception that products are
more differentiated than they really are,
allowing higher markups.

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 The Defense of Advertising
 Defenders of advertising believe:
 It provides useful information to buyers.
 Informed buyers can more easily find and
exploit price differences.
 Thus, advertising promotes competition and
reduces market power.
 Results of a prominent study:
Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers
than in states that did not restrict such advertising.

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 Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts
on advertising may signal the quality of its product
to consumers, regardless of the content of ads.
 Ads may convince buyers to try a product once,
but the product must be of high quality for people
to become repeat buyers.
 The most expensive ads are not worthwhile
unless they lead to repeat buyers.
 When consumers see expensive ads,
they think the product must be good if the company
is willing to spend so much on advertising.
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 Brand Names
 In many markets, brand name products coexist
with generic ones (Any product that can be sold
without a brand name).
 Firms with brand names usually spend more on
advertising, charge higher prices for the products.
 As with advertising, there is disagreement about
the economics of brand names…

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 Generic Product
 A good that is sold using the name for the type of
good that it is, rather than a brand name.
 A generic product is typically not heavily marketed
and competes with other brand name products
largely on a price basis.

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 The Critique of Brand Names
 Critics of brand names believe:
 Brand names cause consumers to perceive
differences that do not really exist.
 Consumers’ willingness to pay (WTP) more for
brand names is irrational, fostered by
advertising.
 Eliminating govt. protection of trademarks
would reduce influence of brand names,
result in lower prices.

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 The Defense of Brand Names
 Defenders of brand names believe:
 Brand names provide information about quality
to consumers.
 Companies with brand names have incentive
to maintain quality, to protect the reputation of
their brand names.

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Sample Questions
(Chapter 16)
Sample Question - 1

Draw a diagram of the long-run equilibrium in a

monopolistically competitive market. How is price related to
average total cost? How is price related to marginal cost?

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Sample Answer - 1

The following figure shows the long-run equilibrium in a

monopolistically competitive market. Price equals average total
cost. Price is above marginal cost.

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Sample Question - 2

Describe the three attributes of monopolistic

competition. How is monopolistic competition like
monopoly? How is it like perfect competition?

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Sample Answer - 2

The three attributes of monopolistic competition are: (1)

there are many sellers; (2) each seller produces a
slightly different product; and (3) firms can enter or exit
the market without restriction. Monopolistic competition
is like monopoly because firms face a downward-
sloping demand curve, so price exceeds marginal cost.
Monopolistic competition is like perfect competition
because, in the long run, price equals average total
cost, as free entry and exit drive economic profit to zero.

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Sample Question - 3

Sleek Sneakers Co. is one of many firms in the market for shoes.
a.Assume that Sleek is currently earning short-run economic profits. On a correctly labeled diagram, show Sleek’s profit-maximizing
output and price, as well as the area representing profit.
b.What happens to Sleek’s price, output, and profit in the long run? Explain this change in words, and show it on a new diagram.
c.Suppose that over time consumers become more focused on stylistic differences among shoe brands. How would this change in
attitudes affect each firm’s price elasticity of demand? In the long run, how will this change in demand affect Sleek’s price, output, and
profits?
d.At the profit-maximizing price you identified in part (c), is Sleek’s demand curve elastic or inelastic? Explain.

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Sample Answer - 3

a. The following figure shows Sleek’s demand, marginal-

revenue, marginal-cost, and average-total-cost curves. The
firm will maximize profit at an output level of Q * and a price of
P *. The shaded are shows the firm’s profits.

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Sample Answer – 3 (cont.)

b. In the long run, firms will enter, shifting the demand for
Sleek’s product to the left. Its price and output will fall. Firms
will enter until profits are equal to zero (as shown in the
following figure).

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Sample Answer – 3 (cont.)

c. As consumers become more focused on the stylistic differences in brands, they will be
less focused on price. This will make the demand for each firm’s products more price
inelastic. The demand curves may become relatively steeper, allowing Sleek to charge a
higher price. If these stylistic features cannot be copied, they may serve as a barrier to
entry and allow Sleek to earn profit in the long run.
d. A firm in monopolistic competition produces where marginal revenue is greater than
zero. This means that firm must be operating on the elastic portion of its demand curve.

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Sample Question - 4

Thirty years ago, the market for chicken was perfectly competitive. Then Frank Perdue began
marketing chicken under his name.

a.How do you suppose Perdue created a brand name for chicken? What did he gain from doing so?

b.What did society gain from having brand name chicken? What did society lose?

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Sample Answer - 4

a. Perdue created a brand name for chicken by advertising.

By doing so, he was able to differentiate his product from
other chicken, gaining market power.

b. Society gained to the extent that Perdue has a great

incentive to maintain the quality of his chicken. Society lost to
the extent that the market for chicken became less
competitive, with the associated deadweight loss.

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END