Chapter 17 Monopolistic Competition

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Chapter 16Monopolistic Competition

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Imperfect CompetitionWe have so far seen two kinds of markets: Perfect competition Many buyers Many sellers All sellers sell the exact same product Monopoly Many buyers One seller, the monopolist These are the two extreme cases Imperfect Competition refers to markets in which the degree of competition among sellers falls somewhere in between these extremes*

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Imperfect CompetitionThere are two main types of Imperfect Competition Monopolistic Competition Many sellers They sell products that are similar but not identical New firms can enter freely, in the long run Oligopoly Only a few sellers The product sold may be identical or similar but not identical New firms find it difficult to enter*

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The Four Types of Market Structures*

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Monopolistic CompetitionThis chapter focuses on monopolistic competition Main features of monopolistic competition Many sellers Product differentiation: similar but non-identical products Free entry and exit*

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Monopolistic Competition: main features 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. This feature of monopolistic competition is shared with perfect competition, which we studied in an earlier chapter So, the decisions made by one firm do not affect other firms in any perceptible way*

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Monopolistic Competition: main features Product Differentiation Each firm produces a product that is at least slightly different from those of other firms. As a result, Rather than being a price taker, each firm faces a downward-sloping demand curve. Monopolistic Competition shares this feature with monopoly, which we studied in an earlier chapter*DemandQuantityPrice

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Monopolistic Competition: main featuresFree Entry or Exit Firms can enter or exit the market without any difficulty. As a result, The number of firms in the market adjusts until economic profits are zero. This is another feature of monopolistic competition that it shares with perfect competition*

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Recap: MonopolyQuantity0Price*

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Déjà vu! Monopolistic Competition in the Short RunQuantity0Price(a) Firm Makes Profit*These profits will not last. Short-run economic profits encourage new firms to enter the market.This reduces the demand faced by firms already in the market (incumbent firms)Incumbent firms’ demand curves shift to the left.Their profits fall…

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Monopolistic Competition: effect of the entry of new firms on an incumbentQuantity0PriceProfit-maximizingquantityPriceDemandMR(a2) Firm Makes Less ProfitATC*These profits will not last either. Profits encourage new firms to enter the market.This reduces the demand faced by incumbent firmsIncumbent firms’ demand curves shift to the left.Their profits fall…

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Monopolistic Competition in the Long RunQuantity0PriceProfit-maximizingquantityDemandMR(a3) Firm Makes No ProfitPrice = ATC*Zero profit

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Monopolistic Competitors in the Short RunQuantity0Price(b) Firm Makes Losses*These losses will not last. Losses force some incumbent firms to exit the market.This will increase the demand faced by the remaining firmsTheir demand curves will shift to the right.Their losses will shrinkIn the long run, profits will be zero!

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Monopolistic Competition in the Long Run, againQuantityPrice0*We have seen that in the long run profits cannot be positive or negative.Therefore, profits must be zero!Note that P = ATC > MR = MC in long run equilibrium.MR = MC

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Monopolistic Competition versus Perfect CompetitionAll firms maximize profits We saw in an earlier chapter that this means MR = MC So, MR = MC is true under both monopolistic and perfect competition Monopolistic competition is like monopoly in the sense that firms face downward-sloping demand curves We saw in the chapter on monopoly that downward-sloping demand curves imply P > MR Monopolistic competition is like perfect competition in the sense that there is free entry in the long run We saw in the chapter on perfect competition that this means P = ATC So, simply by looking at the features of monopoly and perfect competition that are combined in monopolistic competition, we can see that P = ATC > MR = MC *

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Monopolistic Competition versus Perfect CompetitionTwo main differences: excess capacity, and price markup over marginal cost.*

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Monopolistic Competition versus Perfect CompetitionQuantity0Price(a) Monopolistically Competitive FirmQuantity0Price(b) Perfectly Competitive Firm*The long run equilibrium under monopolistic competition shows both excess capacity and a price markup over marginal cost. Under perfect competition, there’s neither. The basic reason for this difference in outcome lies in the difference in the slope of the firm’s demand, which is negatively sloped in monopolistic competition and horizontal under perfect competition.P = ATC > MR = MCP = ATC = MR = MC

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Monopolistic Competition and the Welfare of SocietyMonopolistic competition does not have all the desirable properties of perfect competition.*

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Monopolistic Competition and the Welfare of Society*QuantityPrice0OptimumLong run equilibriumNote that at the optimum outcome P = MC < ATC. So, the optimum can be enforced by a government regulator only through subsidies.

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Monopolistic Competition and the Welfare of SocietyThe markup of price over marginal cost in both monopoly and monopolistic competition leads to deadweight loss However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming. As profits are zero in the long run, regulating a price closer to marginal cost will lead to losses that can be sustained only with subsidies*

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Monopolistic Competition and the Welfare of SocietyAnother 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.*

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Monopolistic Competition and the Welfare of SocietyExternalities of entry include: product-variety externalities business-stealing externalities*

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Monopolistic Competition and the Welfare of SocietyThe 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. *

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ADVERTISINGWhen firms sell differentiated products, each firm has an incentive to advertise in order to attract more buyers to its particular product. Under perfect competition, there is no such incentive Under monopoly, there is some incentive to advertise, but not a whole lot. After all, the monopolist has no rivals.*

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ADVERTISINGFirms that sell highly differentiated consumer goods—such as over-the-counter drugs, perfumes, soft drinks, breakfast cereals—typically spend between 10 and 20 percent of revenue on advertising. Firms that sell industrial products—such as drill presses and communications satellites—typically spend very little on advertizing Firms that sell undifferentiated products—such as wheat, peanuts, or crude oil—spend nothing at all Overall, about 2 percent of total revenue, or over $200 billion a year, is spent on advertising.*

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ADVERTISINGCritics 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.*

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Last Updated: 8th March 2018

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