Chapter 14: Monopolistic Competition
Preface
Firms in monopolistic competition face competition from many other firms that
produce a similar but differentiated product from its own.
Firms in monopolistic competition maximize their profit by producing where MR
= MC.
I. What Is Monopolistic Competition?
A. Monopolistic competition is a market structure in which:
1. A large number of firms compete
2. Each firm produces a differentiated product
3. Firms compete on product quality, price, and marketing
4. Firms are free to enter and exit
B. Large Number of Firms
The large number of firms in a monopolistically competitive industry
implies that each firm has a small market share, no firm can dictate market
conditions, and collusion (conspiring to fix a higher price) is impossible.
C. Product Differentiation
Product differentiation means that each firm makes a product that is
slightly different from the products of competing firms. Some people will
pay more for one variety of a product, so the demand curve for the firm’s
product is downward sloping.
D. Competing on Quality, Price, and Marketing
Product differentiation allows a firm to compete with other firms in product
quality, price, and marketing.
E. Entry and Exit
With no barriers to entry, firms in monopolistically competitive industries
make zero economic profit in the long run.
1
F. Examples of Monopolistic Competition
Examples of a monopolistic industry include audio and video equipment,
sporting goods, and jewelry.
II. Price and Output in Monopolistic Competition
A. Short-Run Output and Price Decision
1. The demand curve for a monopolistically competitive firm is downward
sloping (similar to the demand curve for a monopoly). The downward
sloping demand curve means that the firm’s marginal revenue curve also is
downward sloping and lies below the demand curve.
2. In the short run, a monopolistically competitive firm makes its output and
price decisions just like a monopoly firm. The figure shows a
monopolistically competitive firm’s downward sloping demand curve and
the downward sloping MR curve, which, as noted, lies below the demand
curve.
2
3. The firm maximizes its profit by producing the quantity where MR = MC
and using the demand curve to set the highest price at which people will
buy the quantity it produces. In the figure, the firm produces 20 pizzas per
hour and sets a price of $15 per pizza.
4. The firm earns an economic profit if P > ATC (as is the case for the firm in
the figure). If P = ATC, the firm earns zero economic profit, and if P <
ATC, the firm incurs an economic loss.
5. In the short run, profit maximizing quantity of output might be the loss
minimizing quantity of output.
3
B. Long Run: Zero Economic Profit
1. Unlike a monopoly, firms in monopolistic competition cannot earn
economic profit in the long run. If the firms are earning an economic profit,
other firms enter the market. Entry continues as long as firms in the
industry earn an economic profit. As firms enter, each existing firm loses
some of its market share. The demand for each firm’s product decreases
and the firm’s demand curve shifts leftward.
2. Eventually the demand decreases enough so that the firms earn only a
normal profit, where P = ATC. Entry then stops. This outcome is illustrated
in the figure, in which the firm produces 75 jackets per day (where
MR = MC) and sets a price of $25 per jacket.
C. Monopolistic Competition and Perfect Competition
Unlike firms in perfect competition, firms in monopolistic competition have
excess capacity and a markup:
4
1. Excess Capacity: A firm has excess capacity if it produces less than its
efficient scale, the quantity that minimizes its average total cost. In the long
run, a firm in perfect competition produces at the minimum ATC but, a firm
in monopolistic competition produces less than the quantity that minimizes
the ATC.
2. Markup: A firm’s markup is the amount by which its price exceeds its
marginal cost. A firm in perfect competition has no markup but a firm in
monopolistic competition charges a price that is greater than its marginal
cost of production.
D. Is Monopolistic Competition Efficient?
Firms in monopolistic competition have higher costs than firms in perfect
competition, but firms in monopolistic competition produce variety, which is
valued by consumers. So compared to the alternative of complete
uniformity, monopolistic competition might be efficient.
III. Product Development and Marketing
A. Innovation and Product Development
Monopolistically competitive firms compete through product development
and marketing. New product development allows a firm to gain a temporary
competitive edge and economic profit before competitors imitate the
innovation.
5
B. Advertising
1. Advertising and packaging allow a firm to differentiate its product. Firms in
monopolistic competition incur heavy advertising expenditures which make
up a large portion of the price it charges for the product.
2. Selling costs, such as advertising, are fixed costs that increase the ATC at
any given level of output but do not affect the MC. Advertising efforts are
successful if they increase demand, which can lead to increased profit. But
if all firms advertise, more firms might survive and so the demand for any
one firm is less than otherwise.
3. Heavy marketing and advertising expenditures are a signal to consumers of
a high-quality product. A signal is an action taken by an informed person
(or firm) to send a message to uninformed people.
4. Advertising and brand names might be efficient if they provide consumers
with information about the precise nature of product differences and about
product quality. So the final verdict about the efficiency of monopolistic
competition is ambiguous.
