Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 10

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Monopolistic Competition

• Hall and Lieberman, 3rd edition, Thomson
  South-Western, Chapter 10

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Overview

• What you will learn in this lecture
• Three fundamental characteristics
• Short run equilibrium
• Long run equilibrium
• Excess capacity
• Non price competition

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Motivation of Imperfect Competition

• Advertising is everywhere in the economy
• In perfect competition and monopoly firms do
  little, if any, advertising
• Why?
• Where, then, is all the advertising coming from?
• We must consider firms that are neither perfect
  competitors nor monopolists

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The Concept of Imperfect Competition

• Refers to market structures between perfect
  competition and monopoly
• there is more than one seller, but too few to
  create a perfectly competitive market
• products may not be standardized
• no free entry and exit
• Types of imperfectly competitive markets
• Monopolistic competition
• Oligopoly

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Monopolistic Competition

• Hybrid of perfect competition and monopoly
• Three fundamental characteristics
• Many buyers and sellers
• Sellers offer a differentiated product
• Sellers can easily enter or exit the market
• Examples

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I. Many Buyers and Sellers

• Under monopolistic competition, an individual
  buyer is a price taker
• But an individual seller, in spite of having many
  competitors, decides what price to charge
• Assume that no interaction among firms in market
• Each firm only supplies a small part of the
  market, that none of them needs to worry that its
  actions will be noticedand reacted toby others

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II. Sellers Offer a Differentiated Product

• Each seller produces a somewhat different product
  from the others
• Faces a downward-sloping demand curve
• In this sense is more like a monopolist than a
  perfect competitor
• When it raises its price a modest amount,
  quantity demanded will decline (but not all the
  way to zero)

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II. Sellers Offer a Differentiated Product

• What makes a product differentiated?
• Quality of product
• Tastes a subjective matter
• Whether their perception is accurate or not
• Difference in location
• Thus, whenever a firm faces a downward-sloping
  demand curve, we know buyers perceive its product
  as differentiated
• Firm chooses its price

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III. Easy Entry and Exit

• This feature is shared by monopolistic
  competition and perfect competition
• Plays the same role in both
• Ensures firms earn zero economic profit in
  long-run
• However, no barrier stops any firm from copying
  the successful business of other firms

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Monopolistic Competition in the Short-Run

• Individual monopolistic competitor behaves very
  much like a monopoly
• Key difference is the availability of substitutes
• When a monopolistic competitor raises its price,
  its customers have one additional option
• Can buy similar good from some other firm

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Monopolistically competitive firm making positive
economic profit

MC
P0
ATC
Demand
MR
Quantity
Q0
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Monopolistic Competition in the Long-Run

• Free entry condition
• Continue to occur, and demand curve will continue
  to shift leftward
• Till the time when each firm earns zero economic
  profit
• In real world, monopolistic competitors often
  earn economic profit or loss in the short-run
• Butgiven enough timeprofits attract new
  entrants, and losses result in an industry
  shakeout, until firms are earning zero economic
  profit

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Monopolistically competitive firm making positive
economic profit invites entry, firm demand
shifts inward

MC
P0
ATC
Demand
MR
Quantity
Q0
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Monopolistically competitive firm making positive
economic profit entry continues until profits
are zero

MC
P0
ATC
P1
Demand
Quantity
Q0
Q1
MR
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At equilibrium, P ATC (zero profit) and MR MC

MC
ATC
P0
MR
Quantity
Q0
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Features of monopolistically competitive
industries

• Economy is not efficient - excess capacity
• too little output produced to achieve minimum
  cost per unit
• costly to consumers
• equilibrium price is above minimum ATC
• More firms (varieties) than necessary for least
  cost production
• Benefits
• Consumers usually benefit from product
  differentiation

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Non-price Competition

• Definition Any action a firm takes to increase
  demand for its outputother than cutting its
  price
• Example better service, product guarantees,
  free home delivery, more attractive packaging
• another reason why monopolistic competitors earn
  zero economic profit in long-run
• Costly
• Must pay for advertising, for product guarantees,
  for better staff training
• Shift each firms ATC curve upward