MONOPOLISTIC COMPETITION

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The Concept of Imperfect Competition• Imperfect competition

– A market structure in which there is more than one firm – But one or more of the requirements of perfect

competition is violated• Imperfectly competitive markets

– Monopolistic competition– Oligopoly

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Monopolistic Competition• Monopolistic competition

– A market structure in which there are:• Many firms • Selling products that are differentiated• And in which there is easy entry and exit

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Monopolistic Competition• Sellers offer a differentiated product

– Downward-sloping demand curve• Sell more by charging less• Raise its price without losing all of its customers

– Price setters• Product differentiation

– Quality or location– Can be subjective

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Monopolistic Competition• Many buyers and sellers

– No strategic interaction among firms in the market• Easy entry and exit

– No significant barriers to entry– Zero economic profit in the long run

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Monopolistic Competition in the Short Run • Maximize profit

– Producing where MR=MC• In the short-run

– Economic profit – Zero economic profit – Economic loss

• Demand curve facing a firm– More elastic than under monopoly

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•Like any other firm, a monopolistic competitor maximizes profit by producing the level of output where its MR and MC curves intersect. Kafka Exterminators maximizes profit by servicing 250 homes per month. The profit-maximizing price ($70) is found on the demand curve at an output level of 250 (point A). Profit per unit of $40 is the difference between the price ($70) and average total cost ($30) at output of 250. Total profit is profit per unit times output ($40 × 250 = $10,000), equal to the area of the shaded rectangle.

FIGURE 1: A Monopolistically Competitive Firm in the Short Run

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Dollars

Homes Serviced per Month

ATC

MC

d1

MR1

$70A

250

30

Monopolistic Competition• Economic profit in the short-run; in the

long-run:– New firms enter the market– Existing firms: lose some of its customers– Demand curve shifts left– Long run: zero economic profit

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FIGURE 2: A Monopolistically Competitive Firm in the Long Run

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Dollars

Homes Serviced per Month

ATC

MC

d1

MR1

250d2MR2

$40

1. In the long run, profit attracts entry, which shifts the firm’s demand curve leftward.

100

2. Entry continues until P=ATC at the best output level, and economic profit is zero.

3. The typical firm produces where its new MR crosses MC

E

Monopolistic Competition• Economic loss in the short-run; in the

long-run:– Some firms exit the market– Firms that remain: gain customers– Demand curve shifts right– Long run: zero economic profit

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FIGURE 2: A Monopolistically Competitive Firmin the Long Run

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Dollars

Homes Serviced per Month

ATC

MC

d1

MR1

250d2MR2

$40

1. In the long run, profit attracts entry, which shifts the firm’s demand curve leftward.

100

2. Entry continues until P=ATC at the best output level, and economic profit is zero.

3. The typical firm produces where its new MR crosses MC

E

Monopolistic Competition• Excess capacity under monopolistic

competition– Long-run equilibrium: firm produces on the

downward-sloping portion of its ATC curve• Never at minimum average cost

– Its long-run output level is always too small to minimize cost per unit

– The firm operates with excess capacity12

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FIGURE 2: A Monopolistically Competitive Firm in the Long Run

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Dollars

Homes Serviced per Month

ATC

MC

d1

MR1

250d2MR2

$40

1. In the long run, profit attracts entry, which shifts the firm’s demand curve leftward.

100

2. Entry continues until P=ATC at the best output level, and economic profit is zero.

3. The typical firm produces where its new MR crosses MC

E

•In long-run equilibrium, a monopolistic competitor earns zero profit and operates on the downward-sloping portion of its ATC curve (100 units, at point E). As a result, it does not use enough of its capacity to minimize its average total cost. “Capacity output” (where ATC is minimized) is 200 units. But for any rise in output beyond 100, MR < MC, so profit would decrease (the firm would go from zero to negative profit).

FIGURE 3: Excess Capacity in Monopolistic Competition

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Dollars

Homes Serviced per Month

ATC

MC

200d2

MR2

$40

100

E

LR equilibrium output

“Capacity output”

Monopolistic Competition• Excess capacity and prices

– In the long-run: P > minimum ATC • Higher price under monopolistic competition

than under perfect competition– Because of product differentiation – Consumers usually benefit from product

differentiation

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Monopolistic Competition• Nonprice competition

– Any action a firm takes to shift the demand curve for its output to the right • Better service, product guarantees• Free home delivery, more attractive packaging• Better locations, advertising

– May lead to short run economic profit

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Monopolistic Competition• Nonprice competition

– Zero economic profit in the long-run because:• Imitation by others reverses the initial

rightward shift in demand• The costs of nonprice competition shift the

ATC curve upward

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Advertising in Monopolistic Competition

• Perfect competitors– Never advertise (standardized product)

• Monopolistic competitors– Almost always advertise (differentiated

products)

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• Monopolistic competitor advertises– To shift its demand curve rightward– To make demand for its output less elastic

• Long run– Greater average cost per unit– Each firm sells more: demand curve shifts

right– May raise or lower prices 19

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FIGURE 9: Advertising in Monopolistic Competition (a)

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Dollars

Bottles of Perfume per Month

ATC no ads

dno ads

$100

A

1,750

60

1,000

ATCads

dads

B

1. Before advertising, long-run economic profit is zero.

2. With advertising, in the long run, economic profit returns to zero.

3. Advertising can lead to a higher price in the long run, as in this panel . . .

FIGURE 9: Advertising in Monopolistic Competition (b)

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Dollars

Bottles of Perfumeper Month

ATC no ads

dno ads

50

A

2,000

$60

1,000

ATCads

dads

C

4. or to a lower price in the long run, as in this panel.