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Monopolistic Competition

Chapter 17
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What we learn in this chapter?

• Ch.13 established the cost structure of the firm as
the unit of production in a market economy
• Ch.14 looked at the equlibrium of the firm and of the
market assuming perfect competition
• Ch.15 studied the the causes and the implications of
monopoly as the only seller in a market
• Ch.16 analysed oligopoly as the first case of
imperfect competition
• Ch. 17 deals with the second case of imperfect
competition
• Monopolistic competition refers to situations where a
relatively large number of firms compete but with
non-homogeneous products
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Types of imperfect competition

• We defined imperfect competition as the gray area
between perfect competition and monopoly
• Oligopoly corresponded to the situation when only
few sellers each offering a similar or identical
product as the others exist in the market
• Monopolistic competion is the other case of
imperfectly competitive markets
• There are many firms but each sell a product that is
similar but not identical
• Monopolistic competition corresponds to markets
that have some features of competition and some
features of monopoly because of differentiated
products
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Attributes of monopolistic
competition
• Three characteristics of monopolistic competition
• Many sellers: there are many sellers competing for
the same group of customers
• Product exemples: books, CDs, movies, computer
games, restaurants, furniture, etc.
• Product differentiation: Each firm has a slightly
different product compared with other firms
• Firms therefore face a downward sloping demand
curve
• Free entry or exit: there are no restrictions to entry
and exit, therefore the number of firms in the market
adjust until economic profits are zero.
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Monopolistic competition in the

short run
• In the short run, the equilibrium of the monopolistic-
ally competitive firm resembles that of a monopoly
• In other words it follows the monopolist’s rule for
profit maximisation
• Cut production at the quantity when
MR = MC
• Go to the demand curve to find the selling price for
that quantity
• Therefore marginal cost will always be below price
• But there is one difference with monopoly
• The existence of profits depend on average total cost
level at that quantity
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Monopolistic competition in the

short run
Firm Makes a Profit
Price
MC
ATC

Price
Average
total cost
Profit Demand
MR

0 Profit- Quantity
maximizing quantity
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Monopolistic competition in the

short run
Firm Makes Losses MC
Price ATC
Losses

Average
total cost
Price

Demand
MR

0 Loss- Quantity
minimizing quantity
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From short run to the long run

• The long run equilibrium of the monopolistically
competitive firm resembles perfect competition
• The existence of profits or losses at the short run will
determine the long run behaviour of the market
• Short run profits encourage new firms to enter the
market, meaning more supply of new products
• Demand of incumbent firms fall and their demand
curve shifts left, reducing prices and quantities
• Short run losses imply the opposite
• Some firms exit, therefore there is less supply and
products increasing demand for remaining firms
• Demand curve for remaining firms shifts right and
profits increase
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The long run equilibrium

• The long run equilibrium of a market with mono-
polistic competition is achieved by the entry and exit
of firms depending on short term profits/losses
• In the long run economics profits will be zero
• The long run in equilibrium for monopolistic
competition has elements from both perfect
competition and monopoly
• As in a monopoly price exceeds marginal cost
• Downward sloping demand curve mean that MR
curve is is below the demand curve and MR = MC
• As in a competitive market price equals average cost
• Because free entry and exit drive economic profits
to zero
 Short run loss and long run
equilibrium
Price
MC
ATC

Demand
MR
0
Quantity
 Short run profit and long run
equilibrium
Price
MC
ATC

Demand
MR
0
Quantity
 Monopolistic competition
in the long run
Price
MC
ATC

Demand
MR
0 Long-run Quantity
Profit-maximizing
quantity
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Monopolistic versus perfect

competition: excess capacity
• There are two noteworthy differences between
monopolistic and perfect competition: excess
capacity and mark-up
• In perfect competition in the long run, firms produce
at the point where ATC is minimised (efficient scale)
• There is no excess capacity
• In monopolistic competition in the long run firms
produce output than the efficient scale where ATC is
minimised
• In other words, monopolistic competition implies
excess capacity not only in the short run but also in
the long run
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Excess capacity
Monopolistically Competitive Firm Perfectly Competitive Firm

Price Price
MC MC
ATC ATC

P = MC P = MR
Excess capacity (demand
curve)
Demand

Quantity Quantity
Quantity Efficient Quantity = Efficient
produced scale produced scale
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Mark-up over marginal cost

• For a competitive firm, price equals marginal cost
both in the short and long run due to the horizontal
demand curve (price taker)
P = AR = MR = MC
• For a monopolistically competitive firm price
exceeds marginal cost both in the short and long run
due to downward sloping demand curve (price
maker)
P = AR > MR = MC
• Mark-up means price exceeds marginal cost
• Mark-up pricing implies that an extra unit sold at the
posted price earns more profit for the firm
• Profit volume depends on sale volume
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Mark-up over marginal cost

Monopolistically Competitive Firm Perfectly Competitive Firm

Price Price
Markup MC MC
ATC ATC

P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

Quantity Quantity
Quantity Quantity
produced produced
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Monopolistic competition and the

welfare of society
• Monopolistic competition is less desirable for
society compared with perfect competition
• First and foremost, it causes deadweight loss to the
society due to the markup of price over marginal cost
• Excess capacity in the long run implies unused
scarce resources for the society
• Regulation to achieve the equality of marginal cost
and revenue is not practical because it involves
interfering with the pricing decisions of all the firms
with differentiated products
• Even an efficient and non-corrupt public administra-
tion may find this task impossible
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Monopolistic competition and

externalities
• If the number of firms and products in a market is
not “ideal”, the outcome of monopolistic
competition will not be socially efficient
• The variety of pruducts in the market can be too
large or too small to be socially efficient
• Too much or too little market entry cause positive or
negative externalities
• Externatilities of entry include product-variety
externatility and business-stealing externality
• These are subtle, hard to measure and hard to fix
• There is no easy way public policy can improve the
market outcome
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Advertising and brand names

• A good indicator of monopolistic competition in a
market is the advertising effort made by firms to
convince consumers of the superiority of their
products and to obtain brand loyalty
• The higher the brand loyalty of consumer, the less
elastic will be the demand curve of the firm and
therefore higher its mark-up and profits
• A brand is also a guarantee of quality for the
consumer when it is difficult to establish the quality
of products just by sight
• Brand names dominate many if not most consumer
goods and service industries in the world
• Brands are important assets for those firms
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Debate over advertising

• Advertising and its value to the economy is open to
debate everywhere in the world
• Critics of advertising and brand names contend that
advertising help firms exploit consumers and reduce
competition
• Defenders argue that advertising provides
information and increases competition by offering a
greater variety of products and prices
• Firms that sell highly differentiated consumer goods
typically may spend up to 10 to 20 percent of sales
revenue on advertising
• In the US, total advertising spending stands at 2 % of
revenues (100 billion $)
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Case studies over advertising

• Spending on advertising increases costs of firms
• Do the consumers pay for it through higher prices?
• Evidence must be searched in the real world
• Research undertaken in the US compared two States,
one with a ban on advertising for opticians, the other
without such a ban
• There was considerable difference in the average
prices of eyeglasses in the two States
• The State without advertising ban had lower prices
despite the high cost of advertising
• The State with the ban had higher prices because
there was less competition among opticians
• Benefits of competition outweight cost of advertising
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Conclusion
• Markets with monopolistic competitive are charac-
terised by many firms producing differentiated
products and freedom of entry/exit in the market
• Differentiated products mean a downward sloping
demand curve for the firm (price maker)
• The short run equilibrium of a monopolitically
competitive firm resembles that of a monopoly
• Quantity to be produced is determined at the point
where marginal revenue is equal to marginal cost
• But there may or may not be economic profits
depending on the value of average total cost
• Short run profit and loss will result in new entries or
exits from the market
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Conclusion
• Long run equilibrium is achieved when price equals
average total cost
• In the long-run equilibrium, monopolistically
competitive markets produce with some excess
capacity and each firm charges a price above
marginal cost
• The selling price of a monopolistically competitive
market results in some deadweight losses and
resource misallocations that regulation cannot
practically remedy
• Product differentiation forces firms to advertise and
to establish brands in orter to increase profits
• Advertising may increase competition