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Chapter 17
Monopolistic Competition
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Objectives
1. Recognize imperfect competition amongfirms that sell differentiated products.
2. Understand the equalibrium characteristicsof monopolistic competition.
3. Be able to evaluate the outcomes of monopolistically competitive market.
4. Understand the issues surrounding theeffects of advertising.
5. Understand the debate over the roleof brand names
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The Spectrum of Market Structure
PureCompetition
Chapter 14
PureMonopoly
Chapter 15
ImperfectCompetitionChapters 16 & 17
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Imperfect Competition
Two types of imperfectly competitive markets:
Monopolistic CompetitionMany firms selling products that are similar but
not identical (e.g. movies.)
OligopolyOnly a few sellers, each offering a similar or
identical product to the others (e.g. tennis balls.)
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Monopolistic Competition
Markets that have some features of competition and some features of monopoly.
Attributes of Monopolistic Competition Many Sellers Product Differentiation Free Entry/Exit
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Monopolistic Competition
Monopolistic Competition is a market structure characterized by
1. Many sellers
2. Highly differentiated product
3. Some control over price (pricemaker)
4. Easy entrance and exit from the market
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Attribute: Many Sellers
Many firms competing for the same group of customers.
Examples:– books, CDs, movies,
computer games, restaurants, piano lessons, cookies, furniture, etc.
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Attribute: Product Differentiation
Alternative forms of differentiation:– quality differences; additional service;
location; and packaging.– Toys or prizes with kid’s meals at fast-food
restaurants.
Results in firm facing a downward-sloping demand curve.– Demand curve is highly, but not
perfectly, elastic.
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Attribute: Free Entry or Exit
Firms can enter or exit the market
without restriction.
The number of firms in the market adjusts until
economic profits are zero.
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Monopolistic Competition...
A market structure between perfectly competitive and monopolistic.
Departs from the perfectly competitive because each seller offers a somewhat different product.
Departs from a monopoly because there are many sellers, each of which is small compared to the market.
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Short-Run Operation in Monopolistic Competition
In the short-run, the monopolistically competitive firm:– Follows a monopolist’s rule for profit-
maximization.MR = MCPrice > ATC Price < ATC
– Figure 17-1
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Monopolistically Competitors in the Short-Run
Quantity
MCATC
Q Profit Max.
Price
MR
Demand
ATC
P
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Monopolistically Competitors in the Short-Run
Quantity
MCATC
Q Profit Max.
Price
ATC
P
MR
Demand
P>ATC
Firm Makes Profit
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Monopolistically Competitors in the Short-Run
Quantity
MCATC
Q Loss Min.
Price
P
ATC
MRDemand
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Monopolistically Competitors in the Short-Run
Quantity
MCATC
Q Loss Min.
Price
P
ATC
MRDemand
P<ATCFirm Makes
Losses
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Long-Run Operation in Monopolistic Competition
If firms are making economic profits in the short-run, new firms are encouraged to enter the market.
Results in the following:– Increases the number of products offered– Reduces demand faced by each firm– Demand curves shift to the left, leading to– More elastic demand.
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Long-Run Operation in Monopolistic Competition
Firms will enter and exit until the firms are making exactly zero economic profits.
Two characteristics of monopolistic competition in the long-run:
–Price exceeds marginal cost
–Price equals average total cost– Figure 17-2
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A Monopolistic Competitor in the Long-Run
Quantity
MC
ATC
Q Profit Max.
Price
P=ATC
D
MR
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Monopolistic Competition vs.Perfect Competition
Two differences arise in the long-run between monopolistic competition and perfect competition:
–Excess Capacity
–Markup
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Monopolistic Competition:Excess Capacity
In perfect competition, firms produce at the efficient scale, i.e. the point where average total cost is minimized.
Free entry in competitive markets drive firms to produce at the minimum of average total cost.
Figure 17-3
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The Competitive Firm’s Output in the Long-Run
Quantity
MCATC
P=MR=AR
QEfficient Scale
Price
P=MC
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Monopolistic Competition:Excess Capacity
In monopolistic competition, the quantity of output is less than the “efficient scale” of perfect competition.
A monopolistically competitive firm could increase the quantity it produces and lower the average total cost of production.
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Monopolistically Competitive Output in the Long-Run
Quantity
MCATC
QProduced
Price
MC
P
MR
Demand
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Monopolistically Efficient Output in the Long-Run
Quantity
MCATC
Q
Price
MC
P
MR
Demand
Q Efficient Scale
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Monopolistically Efficient Output in the Long-Run
Quantity
MCATC
Q
Price
MC
P
MR
Demand
Q Efficient Scale
ExcessCapacity
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Monopolistic Competition:Mark Up Over Marginal Cost
For a competitive firm, price equals marginal cost.
For a monopolistically competitive firm, price exceeds marginal cost.
Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistic competitive firm.
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Monopolistically Competitive Output in the Long-Run
Quantity
MCATC
Q
Price
MC
P
MR
Demand
Q Efficient Scale
Mark-Up
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Monopolistic Competition and the Welfare of Society
Inefficiencies may arise and include:The markup price over marginal cost
– Some consumers who value the good at more than the marginal cost of production will be deterred from buying it.
– Results in “deadweight loss” to society.
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Monopolistic Competition and the Welfare of Society
There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.
However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.
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Monopolistic Competition and the Welfare of Society
Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.
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Monopolistic Competition and the Welfare of Society
The number of firms in the market may not be the “ideal” one.– There may be too much or too little entry.
May lead to “externalities” of entry.
– Externalities of Entry: Product-Variety externality Business-Stealing externality
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Monopolistic Competition and the Welfare of Society
The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.
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Monopolistic Competition and the Welfare of Society
The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.
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Quick Quiz!
List the three key attributes of monopolistic competition.
Draw and explain a diagram to show the long-run equilibrium in a monopolistically competitive market.
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Monopolistic Competition: Advertising and Brand Names
Product differentiation leads to advertising and brand names.
Some critics of monopolistic competition contend that advertising and brand name exploit consumers and reduce competition.
Defenders argue that advertising increases competition by offering a greater variety of products and prices.
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Monopolistic Competition: Advertising
Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue for advertising.
As a whole (total economy) about 2 percent of total firm revenue, or over $100 billion a year is spent on advertising.
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Advertising Critics of advertising argue that firms
advertise in order to manipulate people’s tastes.
They also argue that it impedes competition by implying that products are more different than they truly are.
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Advertising Defenders argue that advertising
provides information to consumers They also argue that advertising
increases competition by offering a greater variety of products and prices.
The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.
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Monopolistic Competition: Advertising and Brand Names
Brand Names may provide two benefits to consumers:– Provide consumers information about quality
when quality cannot be easily judged in advance of purchase.
– Give firms an incentive to maintain high quality.
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Brand Names Critics argue that brand names
cause consumers to perceive differences that do not really exist.
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Summary Monopolistically competitive markets
are characterized by many firms each producing a differentiated product with freedom of market entry.
In equilibrium, monopolistically competitive markets produce with some excess capacity and each firm charges a price above marginal cost.
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Summary The selling price of a monopolistic
competitive market results in some deadweight losses and resource misallocation.
Product differentiation leads to advertising and brand names.
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Summary A monopolistically competitive
market is characterized by three attributes: many firms, differentiated products, and free entry.
The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.
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Summary
Monopolistic competition does not have all of the desirable properties of perfect competition.
There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost.
The number of firms can be too large or too small.
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Summary
The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names.
Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition.
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Summary
Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.