MONOPOLISTIC

COMPETITION
Objectives

After studying this chapter, you will able to

 Define and identify monopolistic competition

 Explain how output and price are determined in a
monopolistically competitive industry
 Explain why advertising costs are high in a
monopolistically competitive industry
PC War Games

Each PC maker tells us that they have the best product at

the best price.
Just two big chip makers produce almost all the processor
and memory chips in our PCs.
Firms in these markets are neither price takers like those
in perfect competition, nor are they protected from
competition by barriers to entry like a monopoly.
How do such firms choose the quantity to produce and
price?
Monopolistic Competition

Monopolistic competition is a market with the following

characteristics:
 A large number of firms.
 Each firm produces a differentiated product.
 Firms compete on product quality, price, and marketing.
 Firms are free to enter and exit the industry.
Monopolistic Competition

Large Number of Firms

The presence of a large number of firms in the market
implies:
 Each firm has only a small market share and therefore
has limited market power to influence the price of its
product.
 Each firm is sensitive to the average market price, but no
firm pays attention to the actions of the other, and no one
firm’s actions directly affect the actions of other firms.
 Collusion, or conspiring to fix prices, is impossible.
Monopolistic Competition

Product Differentiation
Firms in monopolistic competition practice product
differentiation, which means that each firm makes a
product that is slightly different from the products of
competing firms.
Monopolistic Competition

Competing on Quality, Price, and Marketing

Product differentiation enables firms to compete in three
areas: quality, price, and marketing.
Quality includes design, reliability, and service.
Because firms produce differentiated products, each firm
has a downward-sloping demand curve for its own
product.
But there is a tradeoff between price and quality.
Differentiated products must be marketed using
advertising and packaging.
Monopolistic Competition

Entry and Exit

There are no barriers to entry in monopolistic competition,
so firms cannot earn an economic profit in the long run.
Examples of Monopolistic Competition
Figure 13.1 on the next slide shows market share of the
largest four firms and the HHI for each of ten industries
that operate in monopolistic competition.
Monopolistic Competition

The red bars

refer to the 4
largest firms.
Green is the
next 4.
Blue is the
next 12.
The numbers
are the HHI.
Output and Price in Monopolistic
Competition

Short-Run Economic Profit

A firm that has decided the quality of its product and its
marketing program produces the profit maximizing
quantity at which its marginal revenue equals its marginal
cost (MR = MC).
Price is determined from the demand curve for the firm’s
product and is the highest price the firm can charge for the
profit-maximizing quantity.
Output and Price in Monopolistic
Competition

Figure 13.2(a) shows a

short-run equilibrium for a
firm in monopolistic
competition.
It operates much like a
single-price monopolist.
Output and Price in Monopolistic
Competition

The firm produces the

quantity at which price
equals marginal cost and
sells that quantity for the
highest possible price.

It earns an economic
profit (as in this example)
when P > ATC.
Output and Price in Monopolistic
Competition

Long Run: Zero Economic Profit

In the long run, economic profit induces entry.
And entry continues as long as firms in the industry earn
an economic profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition
maximizes its profit by producing the quantity at which its
marginal revenue equals its marginal cost, MR = MC.
Output and Price in Monopolistic
Competition

As firms enter the industry, each existing firm loses some

of its market share. The demand for its product decreases
and the demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which
MR = MC and lowers the maximum price that the firm can
charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC and
firms earn zero economic profit.
Output and Price in Monopolistic
Competition

This figure shows a firm in

monopolistic competition
moving from short-run
equilibrium to long-run
equilibrium.
If firms incur an economic
loss, firms exit to restore
the long-run equilibrium
just described.
Output and Price in Monopolistic
Competition

Monopolistic Competition and Efficiency

Firms in monopolistic competition are inefficient and
operate with excess capacity.
Figure 13.3 on the next slide illustrates these propositions.
Output and Price in Monopolistic
Competition

Because they product-

differentiate and face a
downward-sloping
demand curve for their
products, firms in
monopolistic competition
receive a marginal
revenue that is less than
price for all levels of
output.
Output and Price in Monopolistic
Competition

Firms maximize profit by

setting marginal revenue
equal to marginal cost, so
with marginal revenue
less than price, marginal
cost is also less than
price.
Output and Price in Monopolistic
Competition

Because price equals the

marginal benefit, marginal
cost is less than marginal
benefit.
Underproduction in
monopolistic competition
creates deadweight loss.
Output and Price in Monopolistic
Competition

A firm’s capacity output is

the output at which average
total cost is at its minimum.
At the long-run profit
maximizing output, price
equals average total cost.
But recall that MR < P,
which means that MC <
ATC.
Output and Price in Monopolistic
Competition

If MC < ATC, then the

ATC curve is falling.
With output in the range of
falling ATC, output is less
than capacity output.
Goods are not produced
at the minimum unit cost
of production in the long
run.
Product Development and Marketing

Innovation and Product Development

We’ve looked at a firm’s profit-maximizing output decision
in the short run and the long run of a given product and
with given marketing effort.
To keep earning an economic profit, a firm in monopolistic
competition must be in a state of continuous product
development.
New product development allows a firm to gain a
competitive edge, if only temporarily, before competitors
imitate the innovation.
Product Development and Marketing

Innovation is costly, but it increases total revenue.

Firms pursue product development until the marginal
revenue from innovation equals the marginal cost of
innovation.
Production development may benefit the consumer by
providing an improved product, or it may only create the
appearance of a change in product quality.
Regardless of whether a product improvement is real or
imagined, its value to the consumer is its marginal benefit,
which is the amount the consumer is willing to pay for it.
Product Development and Marketing

Marketing
A firm’s marketing program uses advertising and
packaging as the two principal methods to market its
differentiated products to consumers.
Firms in monopolistic competition incur heavy marketing
and advertising expenditures to enhance the perception of
quality differences between their product and rival
products. These costs make up a large portion of the price
for the product.
 ATC AFC AVC
Manufacturer (Asia)
Materials 9.00 9.00
Cost of labor 2.75 2.75
Cost of capital 3.00 3.00
Profit 1.75 1.75
Shipping 0.50 0.50
Import duties 3.00 3.00
Nike (Beaverton, Oregon)
Sales, distribution, and administration 5.00 5.00
Advertising 4.00 4.00
Research and development 0.25 0.25
Nike’s profit 6.25 6.25
Retailer (your town)
Sales clerks’ wages 9.50 9.50
Shop rent 9.00 9.00
Retailer’s other costs 7.00 7.00
Retailer’s profit 9.00 9.00
Totals $70.00 $6.50 $63.50
Product Development and Marketing

Figure 13.4 shows

estimates of the
percentage of sale price
for different monopolistic
competition markets.
Cleaning supplies and toys
top the list at almost 15
percent.
Product Development and Marketing

Selling Costs and Total Costs

Selling costs, like advertising expenditures, fancy retail
buildings, etc. are fixed costs.
Average fixed costs decrease as production increases, so
selling costs increase average total costs at any given
level of output but do not affect the marginal cost of
production.
Selling efforts such as advertising are successful if they
increase the demand for the firm’s product.
Product Development and Marketing

Advertising costs might

lower the average total
cost by increasing
equilibrium output and
spreading their fixed costs
over the larger quantity
produced.
Here, with no advertising,
the firm produces 25 units
of output at an average
total cost of $170.
Product Development and Marketing

With advertising, the firm

produces 130 units of
output at an average total
cost of $160.
The advertising
expenditure shifts the
average total cost curve
upward, but the firm
operates at a higher output
and lower ATC than it
would without advertising.
Product Development and Marketing

But advertising can increase a firm’s demand and profits in

the short run only.
Economic profit leads to entry, which decreases the
demand for each firm’s product in the long run.
To the extent that advertising and selling costs provide
consumers with information and services that they value
more highly than their cost, these activities are efficient.
Oligopoly

Oligopoly is a market in which a small number of firms

compete.
In oligopoly, the quantity sold by one firm depends on the
firm’s own price and the prices and quantities sold by the
other firms.
The response of other firms to a firm’s price and output
influence the firm’s profit-maximizing decision.
Oligopoly

The Kinked Demand Curve Model

In the kinked demand curve model of oligopoly, each firm
believes that if it raises its price, its competitors will not
follow, but if it lowers its price all of its competitors will
follow.
Oligopoly

Figure 13.6 shows the

kinked demand curve
model.
The demand curve that a
firm believes it faces has a
kink at the current price
and quantity.
Oligopoly

Above the kink, demand is

relatively elastic because
all other firm’s prices
remain unchanged.
Below the kink, demand is
relatively inelastic because
all other firm’s prices
change in line with the
price of the firm shown in
the figure.
Oligopoly

The kink in the demand

curve means that the MR
curve is discontinuous at
the current quantity—shown
by the gap AB in the figure.
Oligopoly

Fluctuations in MC that
remain within the
discontinuous portion of the
MR curve leave the profit-
maximizing quantity and
price unchanged.
For example, if costs
increased so that the MC
curve shifted upward from
MC0 to MC1, the profit-
maximizing price and
quantity would not change.
MONOPOLISTIC
COMPETITION

THE
END