Monopolistic Competition

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 Contents
 What market structures lie between perfect
competition and monopoly, and what are their
characteristics?
 How do monopolistically competitive firms choose
price and quantity? Do they earn economic profit?
 In what ways does monopolistic competition affect
society’s welfare?
 What are the social costs and benefits of
advertising?

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 Introduction:
Monopoly and Competition
Two extremes
 Perfect competition: many firms, identical
products
 Monopoly: one firm
In between these extremes: imperfect competition
 Oligopoly: only a few sellers offer similar or
identical products.
 Monopolistic competition: many firms sell
similar but not identical products.

MONOPOLISTIC COMPETITION 3
 Characteristics & Examples
of Monopolistic Competition
Characteristics:
 Many sellers
 Product differentiation
 Free entry and exit
Examples:
 apartments
 books
 bottled water
 clothing
 fast food

MONOPOLISTIC COMPETITION 4
 Comparing Perfect & Monop. Competition
Perfect Monopolistic
competition competition

number of sellers many many

free entry/exit yes yes

long-run econ. profits zero zero

the products firms sell identical differentiated

firm has market power? none, price-taker yes

downward-
D curve facing firm horizontal
sloping

MONOPOLISTIC COMPETITION 5
Comparing Monopoly & Monop. Competition
Monopolistic
Monopoly
competition
number of sellers one many

free entry/exit no yes

long-run econ. profits positive zero

firm has market power? yes yes

downward-
downward-
D curve facing firm sloping
sloping
(market demand)
close substitutes none many
MONOPOLISTIC COMPETITION 6
 A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve. Price
profit MC
At each Q, MR < P. ATC
P
To maximize profit,
ATC
firm produces Q D
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

MONOPOLISTIC COMPETITION 7
 A Monopolistically Competitive Firm
With Losses in the Short Run
For this firm,
P < ATC
Price
at the output where MC
MR = MC.
losses ATC
The best this firm
ATC
can do is to
minimize its losses. P

D
MR
Q Quantity

MONOPOLISTIC COMPETITION 8
 Why Monopolistic Competition Is
Less Efficient than Perfect Competition
1. Excess capacity
 The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
 Under perfect competition, firms produce the
quantity that minimizes ATC.
2. Markup over marginal cost
 Under monopolistic competition, P > MC.
 Under perfect competition, P = MC.

MONOPOLISTIC COMPETITION 9
 Monopolistic Competition and Welfare
 Monopolistically competitive markets do not
have all the desirable welfare properties of
perfectly competitive markets.
 Because P > MC, the market quantity is below
the socially efficient quantity.
 Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
to reduce prices.

MONOPOLISTIC COMPETITION 10
 Monopolistic Competition and Welfare
 Number of firms in the market may not be optimal,
due to external effects from the entry of new firms:
 The product-variety externality:
surplus consumers get from the introduction
of new products
 The business-stealing externality:
losses incurred by existing firms
when new firms enter market
 The inefficiencies of monopolistic competition are
subtle and hard to measure. No easy way for
policymakers to improve the market outcome.

MONOPOLISTIC COMPETITION 11
 Advertising
 In monopolistically competitive industries,
product differentiation and markup pricing
lead naturally to the use of advertising.
 In general, the more differentiated the products,
the more advertising firms buy.
 Economists disagree about the social value of
advertising.

MONOPOLISTIC COMPETITION 12
 The Critique of Advertising
 Critics of advertising believe:
 Society is wasting the resources it devotes to
advertising.
 Firms advertise to manipulate people’s tastes.
 Advertising impedes competition –
it creates the perception that products are
more differentiated than they really are,
allowing higher markups.

MONOPOLISTIC COMPETITION 13
 The Defense of Advertising
 Defenders of advertising believe:
 It provides useful information to buyers.
 Informed buyers can more easily find and
exploit price differences.
 Thus, advertising promotes competition and
reduces market power.
 Results of a prominent study:
Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers
than in states that did not restrict such advertising.

MONOPOLISTIC COMPETITION 14
 Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts
on advertising may signal the quality of its product
to consumers, regardless of the content of ads.
 Ads may convince buyers to try a product once,
but the product must be of high quality for people
to become repeat buyers.
 The most expensive ads are not worthwhile
unless they lead to repeat buyers.
 When consumers see expensive ads,
they think the product must be good if the company
is willing to spend so much on advertising.

MONOPOLISTIC COMPETITION 15
 Brand Names
 In many markets, brand name products coexist
with generic ones.
 Firms with brand names usually spend more on
advertising, charge higher prices for the products.
 As with advertising, there is disagreement about
the economics of brand names…

MONOPOLISTIC COMPETITION 16
 The Critique of Brand Names
 Critics of brand names believe:
 Brand names cause consumers to perceive
differences that do not really exist.
 Consumers’ willingness to pay more for brand
names is irrational, fostered by advertising.
 Eliminating govt protection of trademarks
would reduce influence of brand names,
result in lower prices.

MONOPOLISTIC COMPETITION 17
 The Defense of Brand Names
 Defenders of brand names believe:
 Brand names provide information about quality
to consumers.
 Companies with brand names have incentive
to maintain quality, to protect the reputation of
their brand names.

MONOPOLISTIC COMPETITION 18
 CONCLUSION
 Differentiated products are everywhere;
examples of monopolistic competition abound.
 The theory of monopolistic competition describes
many markets in the economy,
yet offers little guidance to policymakers looking
to improve the market’s allocation of resources.

MONOPOLISTIC COMPETITION 19
SUMMARY

 A monopolistically competitive market has

many firms, differentiated products, and free entry.
 Each firm in a monopolistically competitive market
has excess capacity – produces less than the
quantity that minimizes ATC. Each firm charges a
price above marginal cost.

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SUMMARY

 Monopolistic competition does not have all of the

desirable welfare properties of perfect competition.
There is a deadweight loss caused by the markup
of price over marginal cost. Also, the number of
firms (and thus varieties) can be too large or too
small. There is no clear way for policymakers to
improve the market outcome.

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SUMMARY
 Product differentiation and markup pricing lead to
the use of advertising and brand names. Critics of
advertising and brand names argue that firms use
them to reduce competition and take advantage of
consumer irrationality.
 Defenders argue that firms use them to inform
consumers and to compete more vigorously on
price and product quality.

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