Monopolistic Competition

MONOPOLISTIC
COMPETITION
 Attributes
Attributes of
of Monopolistic
Monopolistic
Competition
Competition
 Many
Many sellers
sellers
 Product differentiation
Product differentiation
 Free entry and exit
Free entry and exit
 Non Price Competition- advertising
Non Price Competition- advertising
 Control over price within a range
Control over price within a range
Monopolistic Competition
 Product Differentiation
 Each firm produces a product that is at
least slightly different from those of other
firms.
 Rather than being a price taker, each firm
faces a downward-sloping demand curve.
Short-run equilibrium of the firm
under monopolistic competition
£ MC
AC
Ps
ACs
AR = D
MR
O Qs Q
 The Monopolistically Competitive Firm in
the Short Run
 Short-run economic profits encourage new
firms to enter the market. This:
 Increases the number of products offered.
 Reduces demand faced by firms already in the
market.
 Incumbent firms’ demand curves shift to the
left.
 Demand for the incumbent firms’ products fall,
and their profits decline.
 The Monopolistically Competitive Firm in
the Short Run
 Short-run economic losses encourage firms

to exit the market. This:
 Decreases the number of products offered.
 Increases demand faced by the remaining
firms.
 Shifts the remaining firms’ demand curves to
the right.
 Increases the remaining firms’ profits.
Long-run equilibrium of the firm
under monopolistic competition
£
LRMC
LRAC
PL
ARL = DL
MRL
O QL Q
The Long Run Equilibrium
 Two Characteristics
 As in a monopoly, price exceeds marginal
cost.
 Profit maximization requires marginal revenue
to equal marginal cost.
 The downward-sloping demand curve makes
marginal revenue less than price.
 As in a competitive market, price equals
average total cost.
 Free entry and exit drive economic profit to
zero.
Long run equilibrium of the firm under
perfect and
monopolistic
£ competition
LRAC
P1
P2
DL under perfect
competition
DL under monopolistic
competition
O Q1 Q2
fig
Q
Monopolistic Competition and
the Welfare of Society
 Monopolistic competition does not have
all the desirable properties of perfect
competition.
 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
 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.
 Externalities of entry include:
 product-variety externalities.
 business-stealing externalities.
 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.
 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.
ADVERTISING
 When firms sell differentiated products and

charge prices above marginal cost, each firm
has an incentive to advertise in order to
attract more buyers to its particular product.
 Firms that sell highly differentiated consumer
goods typically spend between 10 and 20
percent of revenue on advertising.
 Overall, about 2 percent of total revenue, or
over $200 billion a year, is spent on
advertising.
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.
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

 Short-run economic losses encourage firms

 When firms sell differentiated products and

 Critics of advertising argue that firms

 Defenders argue that advertising

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