Monopolistic CompetitionMr. BarnettUHSAP Microeconomics

INTRODUCTION: Between 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.

Comparing Perfect & Monop. Competition

yesnone, price-takerfirm has market power?

downward-sloping

horizontalD curve facing firm

differentiatedidenticalthe products firms sell

zerozerolong-run econ. profits

yesyesfree entry/exit

manymanynumber of sellers

Monopolistic competition

Perfect competition

Comparing Monopoly & Monop. Competition

yesyesfirm has market power?

downward-sloping

downward-sloping (market demand)D curve facing firm

manynoneclose substitutes

zeropositivelong-run econ. profits

yesnofree entry/exit

manyonenumber of sellers

Monopolistic competition

Monopoly

Market Niche

• The more a firm is able to differentiate its products from those of competitors, the greater its ability to set the price above marginal cost.

• Market Niche• Too narrowly defined, the firm may not be able to attract enough

customers • Too broad and the firm faces greater competition. Product

differentiation can be real or perceived.

Real Product Differentiation

Perceived Product Differentiation

Perceived Product Differentiation

• The value of advertising is that it tells you the exact opposite of what the advertiser actually thinks. … If Coke and Pepsi spend billions of dollars to convince you that there are significant differences between these products, both companies realize that Pepsi and Coke are virtually identical. If the advertisement strongly suggests that Nike shoes enable athletes to perform amazing feats, Nike wants you to disregard the fact that shoe brand is unrelated to athletic ability. If Budweiser runs an elaborate advertising campaign stressing the critical importance of a beer's "born-on" date, Budweiser knows this factor has virtually nothing to do with how good a beer tastes. If an advertisement shows a group of cool, attractive youngsters getting excited and high-fiving each other because the refrigerator contains Sunny Delight, the advertiser knows that any real youngster who reacted in this way to this beverage would be considered by his peers to be the world’s biggest nerd. And so on. On those rare occasions when advertising dares to poke fun at the product – as in the classic Volkswagen Beetle campaign-- it’s because the advertiser actually thinks the product is pretty good.”

Differentiation• Increase firm’s costs BUT• consumers focus more on the features of the product than the

product’s price making the product demand more inelastic

• Firms benefit• Able to set price above marginal cost

• Consumers benefit• Choice between differentiated products

Monopolistic Competition and Monopoly

• Short run: Under monopolistic competition, firm behavior is very similar to monopoly. • Long run: In monopolistic competition,

entry and exit drive economic profit to zero. • If profits in the short run:

New firms enter market, taking some demand away from existing firms, prices and profits fall.

• If losses in the short run:Some firms exit the market,remaining firms enjoy higher demand and prices.

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 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.