TUTORIAL 6

GT11103 ECONOMICS
Sem 2, 2023/2024
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Topic: Monopolistic Competition

Part A: Structure Questions

1) 1) List four characteristics of monopolistic competition.

Answer:
i. There are a large number of firms;
ii. each produces a slightly different product;
iii. firms compete on price, quality and marketing; and
iv. firms are free to enter and exit.
As a result of these characteristics, there are no dominant firms and each firms have a small
market share. Because the firms produce differentiated products, firms can charge a markup
and, in the long run, firms have excess capacity.

2) What is product differentiation? What market structure is characterized by product

differentiation?

Answer: A firm practices product differentiation if it makes a product that is slightly different
from the products of competing firms. A differentiated product has close substitutes, but not
perfect substitutes.

3) "A firm in monopolistic competition maximizes its profit by producing where its price is
equal to its marginal cost." Is the previous statement correct or incorrect?

Answer: The statement is incorrect. A firm in monopolistic competition maximizes its profit
by producing where its marginal revenue equals its marginal cost (MR=MC). Because the
marginal revenue is less than the price for a firm in monopolistic competition, it definitely is
not the case that the firm produces where its price equals its marginal cost!

4) How does a firm in monopolistic competition determine its price and quantity? What type
of profit can it make in the short run and the long run?

Answer: The firm produces where its marginal cost equals its marginal revenue. Then the price
is determined from the demand curve and is the highest price at which people will buy the
quantity produced. The firm can make a positive economic profit, zero economic profit, or
incur an economic loss in the short run. In the long run, the firm cannot make an economic
profit; it can only make zero economic profit, that is, its owners make a normal profit.

5) How do product development and marketing affect a firm in monopolistic competition?

Answer: Product development and marketing have two effects on a firm. First, because these
activities are costly, they increase the firm's costs and shift its costs curves upward. Second,
they can increase the demand for the firm's products.
6) Explain the role of advertising in monopolistic competition. Describe how advertising by all
firms in a monopolistically competitive industry impacts a firm's ATC curve, its MC curve, its
demand curve, and its MR curve.

Answer: In order to maintain (or regain) economic profit, a firm in monopolistic competition
must continually develop new products that are unique and/or of high quality (or make
consumers believe this). Advertising lets firms signal this information. So all firms in
monopolistic competition tend to advertise extensively.

Advertising is a fixed cost and it shifts the ATC curve upward. Even though advertising shifts
to the ATC curve upward, the total average cost might be lower if it increases the amount sold
by enough. Because advertising is a fixed cost, it has no effect on the marginal cost, so the MC
curve does not change. Because all firms advertise, advertising might or might not increase
demand for a specific firm. When all firms advertise, the demand curve and marginal revenue
curve for a specific firm become more elastic.

Part B: Multiple-choice Questions

1) Which of the following is part of the market structure for monopolistic competition?
A) no barriers to entry
B) a large number of firms compete
C) each firm produces a differentiated product
D) All the above answers are correct.
Answer: D

2) Product differentiation exists within an industry if

A) there are no substitutes for a product.
B) there are close but not perfect substitutes for a product.
C) the firm can sell all it wants at the chosen price.
D) there is a monopoly.
Answer: B

3) Firms in monopolistic competition can achieve product differentiation by

A) expanding plant size.
B) exploiting economies of scale in production.
C) advertising special characteristics.
D) setting the price equal to average revenue.
Answer: C

4) The best example of a good sold in a monopolistically competitive market is

A) pizza.
B) the local newspaper.
C) sewer services.
D) peaches.
Answer: A

5) When firms in monopolistic competition incur an economic loss, some firms will
A) enter the industry and produce more products.
B) exit the industry, and demand will increase for the firms that remain.
C) exit the industry, and demand will decrease for the firms that remain.
D) enter the industry, and demand will become more elastic for the original firms.
Answer: B

6) Advertising costs are ________ costs and the per unit cost of advertising ________ as production
increases.
A) fixed; increases
B) variable; increases
C) fixed; decreases
D) variable; does not change
Answer: C

7) Brand name aspirin is chemically identical to store brand aspirin. Yet, consumers often prefer the
brand name product to the store brand product. This preference is an example of
A) product differentiation.
B) perfect product competition.
C) oligopolistic product competition.
D) price taking behavior.
Answer: A