Monopolistic Competition

The Meaning of Monopolistic Competition
Monopolistic competition is a market structure in which

there are many competing producers in an industry,
each producer sells a differentiated product, and

there is free entry into and exit from the industry in the long run.
Product Differentiation
Product differentiation plays an even more crucial role in monopolistically competitive industries. Why?
Tacit collusion is virtually impossible when there are
many producers. Hence, product differentiation is the only way monopolistically competitive firms can acquire some market power.
Then, how do firms in the same industrysuch as fast-food vendors, or chocolate companies differentiate their products? Is the difference mainly in the minds of consumers or in the products themselves?
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There are three important forms of product differentiation: Differentiation by style or type Differentiation by location Dry cleaner near home vs. Cheaper dry-cleaner far away Differentiation by quality Ordinary vs. high quality products
Whatever form it takes, however, there are two important features of industries with differentiated products:
Competition
the same market, so entry by more producers reduces the quantity each existing producer sells at any given price.
among sellers: Producers compete for
Value
the increased diversity of products.
in diversity: In addition, consumers gain from
Economics in Action:
Case: Any Color, So Long as Its Black Fords strategy was to offer just one style of car, which maximized his economies of scale but made no concessions to differences in taste Model T
Alfred P. Sloan of GM challenged this strategy by offering a range of car types, differentiated by quality and price Chevrolet, Cadillac, Buick
By the 1930s the verdict was clear: Customers preferred a range of styles!
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Understanding Monopolistic Competition

As the term monopolistic competition suggests, this market structure combines some features typical
of monopoly with others typical of perfect competition:
Because each firm is offering a distinct product, it is in a way like a monopolist: it faces a downward-sloping demand curve and has some market powerthe ability within limits to determine the price of its product. However, unlike a pure monopolist, a monopolistically competitive firm does face competition: the amount of its product it can sell depends on the prices and products offered by other firms in the industry.
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Understanding Monopolistic Competition: The Monopolistically Competitive Firm in the Short Run
The following figure shows two possible situations that a typical firm in a monopolistically competitive industry might face in the short run.
In each case the firm looks like any monopolist: it faces a downward-sloping demand curve, which implies a downward-sloping marginal revenue curve. We assume that every firm has an upward-sloping marginal cost curve but that it also faces some fixed costs, so that its average total cost curve is U-shaped.
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The firm in panel (a) can be profitable for some output levels: the levels at which its ATC, lies below its demand curve, DP. The profit-maximizing output level is QP, the output at which marginal revenue, MRP, is equal to marginal cost. The firm charges price PP and earns a profit, represented by the area of the shaded rectangle.
The firm above can never be profitable because the ATC lies above its demand curve, DU. The best that it can do if it produces at all is to produce output QU and charge PU. This generates a loss, indicated by the area of the shaded rectangle. Any other output level 8 results in a greater loss.
Monopolistic Competition in the Long Run

If the typical firm earns positive profits, new firms will enter the industry in the long run, shifting each existing firms demand curve to the left. If the typical firm incurs losses, some existing firms will exit the industry in the long run, shifting the demand curve of each remaining firm to the right. In the long run, equilibrium of a monopolistically competitive industry, the zero-profit-equilibrium, firms just break even. The typical firms demand curve is just tangent to its average total cost curve at its profitmaximizing output.
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Entry and Exit into the Industry Shift the Demand Curve of Each Firm
Entry will occur in the long run when existing firms are profitable. In panel (a), entry causes each firms demand curve and marginal revenue curve to shift to the left. The firm receives a lower price for every unit it sells, and its profit falls. Entry will cease when remaining firms make zero profit.
Exit will occur in the long run when existing firms are unprofitable. In panel (b), exit out of the industry shifts each remaining firms demand curve and marginal revenue curve to the right. The firm receives a higher price for every unit it sells, and profit 10 rises. Exit will cease when the remaining firms make zero profit.
The Long-Run Zero-Profit Equilibrium

A monopolistically competitive firm is like a monopolist without monopoly profits.
If existing firms are profitable, entry will occur and shift each firms demand curve leftward. If existing firms are unprofitable, each firms demand curve shifts rightward as some firms exit the industry. In long-run zero profit equilibrium, the demand curve of each firm is tangent to its average total cost curve at its profitmaximizing output level: at the profit-maximizing output level, 11 QMC, price, PMC, equals average total cost, ATCMC.
Monopolistic Competition versus Perfect Competition

In the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit. Price exceeds marginal cost so some mutually beneficial trades are exploited. The following figure compares the long-run equilibrium of a typical firm in a perfectly competitive industry with that of a typical firm in a monopolistically competitive industry.
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Panel (a) shows the situation of the typical firm in long-run equilibrium in a perfectly competitive industry. The firm operates at the minimum-cost output QC , sells at the competitive market price PC , and makes zero profit. It is indifferent to selling another unit of output because PC is equal to its marginal cost, MCC . Panel (b) shows the situation of the typical firm in long-run equilibrium in a monopolistically competitive industry. At QMC it makes zero profit because its price, PMC, just equals average total cost. At QMC the firm would like to sell another unit at price PMC, since PMC exceeds marginal cost, MCMC. But it is unwilling to lower price to make more sales. It therefore operates to the left of the minimum-cost output and has excess 13 capacity.
Is Monopolistic Competition Inefficient?

Firms in a monopolistically competitive industry have excess capacity: they produce less than the output at which average total cost is minimized. The higher price consumers pay because of excess capacity is offset to some extent by the value they receive from greater diversity. Hence, it is not clear that this is actually a source of inefficiency.
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Controversies about Product Differentiation

No discussion of product differentiation is complete without spending at least a bit of time on the two related issuesand puzzlesof:
advertising and brand names
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The Role of Advertising

In industries with product differentiation, firms advertise in order to increase the demand for their products.
Advertising is not a waste of resources when it gives consumers useful information about products. Either consumers are irrational, or expensive advertising communicates that the firm's products are of high quality.
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Brand Names
Some firms create brand names.
A brand name is a name owned by a particular firm that distinguishes its products from those of other firms. As with advertising, the social value of brand names can be ambiguous.
The names convey real information when they assure consumers of the quality of a product.
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Monopolistic Competition

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The Meaning of Monopolistic Competition

Monopolistic competition is a market structure in which

each producer sells a differentiated product, and

Tacit collusion is virtually impossible when there are

among sellers: Producers compete for

the increased diversity of products.

in diversity: In addition, consumers gain from

Understanding Monopolistic Competition

of monopoly with others typical of perfect competition:

Monopolistic Competition in the Long Run

The Long-Run Zero-Profit Equilibrium

Monopolistic Competition versus Perfect Competition

Is Monopolistic Competition Inefficient?

Controversies about Product Differentiation

The Role of Advertising

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