TOPIC 20

Monopolistic competition

MONOPOLISTIC COMPETITION

• Recall types of imperfectly competitive

markets
– Monopolistic competition
• Many firms selling similar but not identical products.

– Oligopoly
• A few sellers, each offering a similar or identical product.

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MONOPOLISTIC COMPETITION
Number of firms?

Many
firms

Type of products?

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly competition competition
(today)

• Tap water • Cigarettes • Novels • Wheat

• Electricity • Crude oil • Movies • Milk
transmission

MONOPOLISTIC COMPETITION

• Markets with some features of competition &

some of monopoly.
– Many sellers: there are many firms competing for
the same group of customers.
– Product differentiation: each firm produces a
product that is slightly different from those of other
firms.
• Rather than being a price taker, each firm faces a
downward-sloping demand curve.

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 MONOPOLISTIC COMPETITION

– Free entry and exit: in the long run, firms can

enter (or exit) the market without restriction.
• The number of firms in the market adjusts until economic
profits are driven to zero.

• Examples include most small retail stores

bookstores, restaurants, furniture producers
& retailers, etc.

MONOPOLISTIC COMPETITION IN
THE SHORT RUN
• In the short-run monopolistically competitive
firms, operate exactly as monopolists.
– They take advantage of the downward-sloping
demand that they face.
– They select output so MR=MC.
– If, at this point, price exceeds average total cost,
the firm makes a profit.
• The firm produces profit maximising output
– If, at this point, price is less than average total
cost, the firm makes a profit.
• The firm produces loss minimising output

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MONOPOLISTIC COMPETITION IN
THE SHORT RUN

MONOPOLISTIC COMPETITION IN
THE SHORT RUN

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 MONOPOLISTIC COMPETITION IN
THE LONG RUN
• Unlike monopoly, monopolistically competitive
firms cannot sustain their profits in the long run
as there is free entry.

• When firms are making profits in the short run,

new firms have an incentive to enter the
market.
– Entry increases the number of products offered
– Reduces the demand for each firm already in the
market (demand curve shifts left).
– Decreases original firms’ profits

MONOPOLISTIC COMPETITION IN
THE LONG RUN
• Firms will continue to enter until all are making
exactly zero economic profits.

• This occurs by demand curve shifting to the left

until it is tangent to the firm’s average cost
curve.
– Graph in the class

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 MONOPOLISTIC COMPETITION IN
THE LONG RUN
• Conversely, monopolistically competitive firms
do not sustain losses in the long run as there is
free exit.

• When existing firms are making losses in the

short run, some firms are discouraged and exit
the market.
– Exit decreases the number of products offered
– Increases the demand for each remaining firm in the
market (demand curve shifts right).
– Decreases remaining firms’ losses

MONOPOLISTIC COMPETITION IN
THE LONG RUN
• Firms will continue to exit until all that remain
are making exactly zero economic profits.

• This occurs by demand curve shifting to the

right until it is tangent to the firm’s average cost
curve.
– Graph in the class

• Because of these shifts in demand, the firm

eventually finds itself where the firm earns zero
profit.

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 MONOPOLISTIC COMPETITION IN
THE LONG RUN

MONOPOLISTIC COMPETITION IN
THE LONG RUN
• Notice that the demand curve just touches the
average total cost curve.
– The two curves are tangential to each other.
– i.e. P = AC

• Also note that this point of tangency occurs at

the same quantity where
– marginal revenue equals marginal cost.
– i.e. MR = MC

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 MONOPOLISTIC COMPETITION IN
THE LONG RUN
• Two characteristics
– As in monopoly, P > MC ( it is a ‘mark-up’ on MC).
• Profit maximisation requires MR = MC.
• The downward-sloping demand however makes
MR < price.

– As in competitive markets, in the long-run P = AC.

• Free entry & exit drive economic profit to zero.

MONOPOLISTIC VS PERFECT
COMPETITION
• Since P > MC under monopolistic competition
the price charged is higher than that charged
under perfect competition (the social optimum;
P = MC).

• Although price charged by monopolistically

competitive firms is ‘too high’ they still make no
profits.
– Since P = AC no pure profits are earned

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 MONOPOLISTIC VS PERFECT
COMPETITION
• That a monopolistic competitive firm prices
‘too high’ means that it produces too little
– it produces less than a competitive firm would.

• Since a competitive firm produces at minimum

average cost this means that a monopolistically
competitive firm does not produce enough to
minimise average costs.

MONOPOLISTIC VS PERFECT
COMPETITION
• Thus a monopolistically competitive firm
operates with excess capacity.
– The quantity of output at this point is smaller than
the efficient scale.

• The difference between the profit maximising

quantity and the efficient scale is known as the
excess capacity of the firm.

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 MONOPOLISTIC VS PERFECT
COMPETITION

COMMENTS ON EXCESS CAPACITY

• It is only when demand is perfectly elastic
(‘flat’) –that no excess capacity occurs.
– This is the case of perfect competition.

• Get excess capacity under monopolistic

competition in the long-run because the firm’s
demand curve slopes down.

• The ‘steeper’ the demand curve (the less

elastic it is) the more the excess capacity.

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MONOPOLISTIC COMPETITION AND
THE WELFARE OF SOCIETY
• Monopolistic competition doesn’t have the
desirable properties of perfect competition.
– One source of inefficiency is the mark-up of price
over marginal cost, creating a deadweight loss.
– The other source of inefficiency is the excess
capacity

REGULATION OF MONOPOLISTIC
COMPETITION
• Provided that demands are not very inelastic
– the DWLs due to mark-up pricing will not be large.
– the inefficiencies associated with excess capacity will
also not be high.
• Since policymakers would need to regulate a
large number of firms that produce differentiated
products.
– the administrative burden of such regulation would be
overwhelming.
• Perhaps best not to regulate

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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 ‘ideal’.
• Whenever a new firm considers entering the
market with a new product, it considers only
the profit it would make.

MONOPOLISTIC COMPETITION AND

THE WELFARE OF SOCIETY
• There are some gains from monopolistic
competition over perfect competition as well.
– The product-variety externality: Consumers are
better off from the introduction of a new product as it
provides them with a greater variety. So entry of a
new firm conveys a positive externality on
consumers.
– It is therefore not clear whether consumers lose due
to mark-up pricing
• If you can get one type of restaurant meal for $10 but had
to pay $14 to have the option of choosing between a range
of meals (Thai, Chinese etc) are you worse off?

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 ADVERTISING
• When firms sell differentiated products or
unique products each firm has an incentive to
advertise to attract more buyers to its particular
product.

• Some oligopolies & some monopolistically

competitive firms will advertise.

• Firms that sell highly differentiated consumer

goods might spend 10-20% of revenue on
advertising.

THE DEBATE ABOUT ADVERTISING

• Critique of advertising:
– Firms advertise in order to manipulate people’s
preferences.
• Commercials create a desire that otherwise might not exist.
– Advertising impedes competition.
• Advertising often tries to increase the perception of product
differentiation and foster brand loyalty.
• When a firm faces a less elastic demand curve, it can
increase its profits by charging a larger mark-up over
marginal cost.

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THE DEBATE ABOUT ADVERTISING
• In defence of advertising:
– Advertising provides information to customers.
• Advertising conveys the prices of the goods being offered
for sale, the existence of new products and the locations of
retail outlets.
• The availability of this information can increase competition
by allowing consumer to more readily compare the
offerings of different firms.
– The signalling theory states that an advertiser
signals the quality of its product by its willingness to
spend money on advertising.
• Expensive advertising will only be profitable if the product
is high quality and consumers buy repeatedly.

BRAND NAMES

• In some markets, there are two types of firms.

– Some firms sell products with widely recognised
brand names and
– other firms sell generic substitutes.

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THE DEBATE ABOUT BRAND NAMES

• The critique of brand names:

– Brand names cause consumers to perceive
differences that do not really exist.
– Consumers’ willingness to pay more for the brand-
name good is a form of irrationality fostered by
branding.

THE DEBATE ABOUT BRAND NAMES

• In defence of brand names:

– Brand names provide consumers with information
about quality when quality cannot be easily judged
in advance of purchase.
– Brand names give firms an incentive to maintain
high quality, since firms have a financial stake in
maintaining the reputation of their brand names.

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 SUMMARY
• A monopolistically competitive market is
characterised by three attributes: many firms,
differentiated products & free entry (or exit).

• The equilibrium in a monopolistically

competitive market differs from perfect
competition in that each firm has higher
average costs & each firm charges a price
above marginal cost.

SUMMARY
• Monopolistic competition does not have all of
the desirable properties of perfect competition.

• There is a standard DWL of monopoly caused

by the mark-up of price over marginal cost.

• In addition there are efficiency losses

associated with excess capacity.

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 SUMMARY
• The product differentiation inherent in
monopolistic competition leads to the use of
advertising & brand names.

• Critics argue that firms use advertising & brand

names to take advantage of consumer
irrationality & to reduce competition.

• Defenders argue that firms use advertising &

brand names to inform consumers & to
compete more vigorously on price & product
quality.

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