Business Economics

Chapter: Monopolistic Competition

Biplab Kumar Guru
Assistant Professor
KIIT University
Monopolistic Competition

• Imperfect competition refers to those market structures that fall between

perfect competition and pure monopoly.
Monopolistic Competition

• Types of Imperfectly Competitive Markets

• Monopolistic Competition
• Many firms selling products that are similar but not identical.
• Oligopoly
• Only a few sellers, each offering a similar or identical product to the others.
Monopolistic Competition

• Markets that have some features of competition and

some features of monopoly.
• Characteristics
• Many firms/sellers
• Differentiated products
• Limited control over price
• Few entry barriers
• Free entry and exit
• Much non-price competition – many ads, brands
• Examples: retail trade, clothing, restaurants
Monopolistic Competition

• Many Sellers
• There are many firms competing for the same group of
customers.
• Product examples include books, CDs, movies, computer games,
restaurants, piano lessons, cookies, furniture, etc.
Monopolistic Competition

• Product Differentiation

• Each firm produces a product that is at least slightly

different from those of other firms.

• Rather than being a price taker, each firm faces a

downward-sloping demand curve.
Monopolistic Competition

• Free Entry or Exit

• Firms can enter or exit the market without restriction.
• The number of firms in the market adjusts until economic
profits are zero.
COMPETITION WITH DIFFERENTIATED PRODUCTS

• The Monopolistically Competitive Firm in the Short Run

• Short-run economic profits encourage new firms to enter the market. This:
• Increases the number of products offered.
• Reduces demand faced by firms already in the market.
• Incumbent firms’ demand curves shift to the left.
• Demand for the incumbent firms’ products fall, and their profits decline.
Figure 1 Monopolistic Competition in the Short Run

(a) Firm Makes Profit

Price

MC

ATC

Price
Average
total cost
Profit Demand

MR

0 Profit- Quantity
maximizing
quantity
Copyright©2003 Southwestern/Thomson Learning
COMPETITION WITH DIFFERENTIATED PRODUCTS

• The Monopolistically Competitive Firm in the Short Run

• Short-run economic losses encourage firms to exit the market. This:
• Decreases the number of products offered.
• Increases demand faced by the remaining firms.
• Shifts the remaining firms’ demand curves to the right.
• Increases the remaining firms’ profits.
Figure 1 Monopolistic Competitors in the Short Run

(b) Firm Makes Losses

Price

MC
ATC
Losses

Average
total cost
Price

MR Demand

0 Loss- Quantity
minimizing
quantity
Copyright©2003 Southwestern/Thomson Learning
The Long-Run Equilibrium

• Firms will enter and exit until the firms are making exactly zero economic
profits.
• Produce at MR=MC and with ATC curve tangent to the demand function.
Monopolistic Competition

P>ATC Firm earning profits P<ATC Firm suffering loss

Firms enter Firms exit
 Monopolistic Competition

Since the firm in the monopolistic competitive market is making profits, makes more firms enter the market, which decreases the demand and
marginal revenue of the firm. Causes profits go to zero
 Figure 2 A Monopolistic Competitor in the Long Run

Price

MC
ATC

P = ATC

Demand
MR
0
Profit-maximizing Quantity
quantity

Copyright©2003 Southwestern/Thomson Learning

Long-Run Equilibrium

• Two Characteristics
• As in a monopoly, price exceeds marginal cost.
• Profit maximization requires marginal revenue to equal marginal cost.
• The downward-sloping demand curve makes marginal revenue less than price.
• As in a competitive market, price equals average total cost.
• Free entry and exit drive economic profit to zero.
Monopolistic versus Perfect Competition

• There are two noteworthy differences between monopolistic and perfect

competition—excess capacity and markup.
Monopolistic versus Perfect Competition

• Excess Capacity
• There is no excess capacity in perfect competition in the
long run.
• Free entry results in competitive firms producing at the point
where average total cost is minimized, which is the efficient
scale of the firm.
• There is excess capacity in monopolistic competition in the
long run.
• In monopolistic competition, output is less than the efficient
scale of perfect competition.
• Monopolistic competition will be inefficient due to the
excess capacity
Figure 3 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC

P
P = MC P = MR
(demand
curve)

MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Copyright©2003 Southwestern/Thomson Learning

Monopolistic versus Perfect Competition

• Markup Over Marginal Cost

• For a competitive firm, price equals marginal cost.
• For a monopolistically competitive firm, price exceeds marginal cost.
• Because price exceeds marginal cost, an extra unit sold at the posted price means
more profit for the monopolistically competitive firm.
 Figure 3 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC
Markup

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

0 Quantity Quantity 0 Quantity produced Quantity

produced

Copyright©2003 Southwestern/Thomson Learning

 Figure 3 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC
Markup

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Excess capacity

Copyright©2003 Southwestern/Thomson Learning

Monopolistic Competition
and the Welfare of Society

• Monopolistic competition does not have all the desirable

properties of perfect competition.

• Inefficient compared to perfect competition, restricts

output level in order to maximize profits
Monopolistic Competition
and the Welfare of Society

• There is the normal deadweight loss of monopoly pricing

in monopolistic competition caused by the markup of
price over marginal cost.

• However, the administrative burden of regulating the

pricing of all firms that produce differentiated products
would be overwhelming.
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 the “ideal” one. There may be too much or
too little entry.

• Externalities of entry include:

• product-variety externalities.
• business-stealing externalities.
Monopolistic Competition
and the Welfare of Society

• The product-variety externality:

• Because consumers get some consumer surplus from the introduction
of a new product, entry of a new firm conveys a positive externality on
consumers.

• The business-stealing externality:

• Because other firms lose customers and profits from the entry of a new
competitor, entry of a new firm imposes a negative externality on
existing firms.
Non-price competition

• Advertising
• Unique products
• Warranties
• Coupons
• Rewards for frequent customers
• Appeal to brand or store names
Advertisement
ADVERTISING

• When firms sell differentiated products and charge prices

above marginal cost, each firm has an incentive to advertise
in order to attract more buyers to its particular product.

• Firms that sell highly differentiated consumer goods typically

spend between 10 and 20 percent of revenue on advertising.
Advertising

• Firms in competitive markets don’t advertise

• Don’t see advertisement for wheat, oil, or corn

• Firms that sell industrial products don’t advertise as well

ADVERTISING

• Critics of advertising argue that firms advertise in order to

manipulate people’s tastes.
• They also argue that it impedes competition by implying
that products are more different than they truly are.
• Example soft drink: does not advertise the product’s
price, quality, or ingredients
• But it does show a group of people at the beach happy
basically telling us subconsciously, “You too can have
many friends and be happy, if only you drink our
product.”
ADVERTISING

• Defenders argue that advertising provides information to

consumers

• They also argue that advertising increases competition by offering

a greater variety of products and prices.

• The willingness of a firm to spend advertising dollars can be a signal

to consumers about the quality of the product being offered.

• Can lead to greater competition and lower prices.

Brand Names

• Critics argue that brand names cause consumers to perceive

differences that do not really exist.
• Economists have argued that brand names may be a useful
way for consumers to ensure that the goods they are buying
are of high quality.
• providing information about quality.
• giving firms incentive to maintain high quality
• Brand names vs. generic: some generic are the same as
brand names.
• Drive through town and have to pick between McDonald’s
and Earl’s Hamburger Hut. Which do you choose?
Summary

• A monopolistically competitive market is characterized by

three attributes: many firms, differentiated products, and free
entry.

• The equilibrium in a monopolistically competitive market

differs from perfect competition in that each firm has excess
capacity and 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 deadweight loss of monopolistic
firms caused by the markup of price over marginal
cost.
• The number of firms can be too large or too small.
Summary

• The product differentiation inherent in monopolistic

competition leads to the use of advertising and brand names.
• Critics argue that firms use advertising and brand names to take
advantage of consumer irrationality and to reduce competition.
• Defenders argue that firms use advertising and brand names to inform
consumers and to compete more vigorously on price and product
quality.
THANK YOU