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C H A P T E R

Monopolistic Competition

Microeconomics P R I N C I P L E S O F

N. Gregory Mankiw

Premium PowerPoint Slides

by Ron Cronovich

16

In this chapter,

look for the answers to these questions:

 What market structures lie between perfect

competition and monopoly, and what are their

characteristics?

 How do monopolistically competitive firms choose

price and quantity? Do they earn economic profit?

 In what ways does monopolistic competition affect

society’s welfare?

 What are the social costs and benefits of

advertising? 1

MONOPOLISTIC COMPETITION 2

Introduction: Between Monopoly and Competition

Two extremes

 Perfect competition: many firms, identical

products

 Monopoly: one firm

In between these extremes: imperfect competition

 Oligopoly: only a few sellers offer similar or

identical products.

 Monopolistic competition: many firms sell

similar but not identical products.

MONOPOLISTIC COMPETITION 3

Characteristics & Examples of Monopolistic Competition

Characteristics:

 Many sellers

 Product differentiation

 Free entry and exit

Examples:

 apartments

 books

 bottled water

 clothing

 fast food

 night clubs

MONOPOLISTIC COMPETITION 4

Comparing Perfect & Monop. Competition

yesnone, price-takerfirm has market power?

downward-

sloping horizontalD curve facing firm

differentiatedidenticalthe products firms sell

zerozerolong-run econ. profits

yesyesfree entry/exit

manymanynumber of sellers

Monopolistic

competition

Perfect

competition

MONOPOLISTIC COMPETITION 5

Comparing Monopoly & Monop. Competition

yesyesfirm has market power?

downward-

sloping

downward-

sloping

(market demand)

D curve facing firm

manynoneclose substitutes

zeropositivelong-run econ. profits

yesnofree entry/exit

manyonenumber of sellers

Monopolistic

competition Monopoly

MONOPOLISTIC COMPETITION 6

profit

ATC

P

A Monopolistically Competitive Firm Earning Profits in the Short Run

The firm faces a

downward-sloping

D curve.

At each Q, MR < P.

To maximize profit,

firm produces Q

where MR = MC.

The firm uses the

D curve to set P. Quantity

Price

ATC

D

MR

MC

Q

MONOPOLISTIC COMPETITION 7

losses

A Monopolistically Competitive Firm With Losses in the Short Run

For this firm,

P < ATC

at the output where

MR = MC.

The best this firm

can do is to

minimize its losses.

Quantity

Price

ATC

Q

P

ATC

MC

D

MR

MONOPOLISTIC COMPETITION 8

Monopolistic Competition and Monopoly

 Short run: Under monopolistic competition,

firm behavior is very similar to monopoly.

 Long run: In monopolistic competition,

entry and exit drive economic profit to zero.

 If profits in the short run:

New firms enter market,

taking some demand away from existing firms,

prices and profits fall.

 If losses in the short run:

Some firms exit the market,

remaining firms enjoy higher demand and prices.

MONOPOLISTIC COMPETITION 9

A Monopolistic Competitor in the Long Run

Entry and exit

occurs until

P = ATC and

profit = zero.

Notice that the

firm charges a

markup of price

over marginal cost

and does not

produce at

minimum ATC. Quantity

Price

ATC

D

MR

Q

MC

MC

P = ATC

markup

MONOPOLISTIC COMPETITION 10

Why Monopolistic Competition Is Less Efficient than Perfect Competition

1. Excess capacity

 The monopolistic competitor operates on the

downward-sloping part of its ATC curve,

produces less than the cost-minimizing output.

 Under perfect competition, firms produce the

quantity that minimizes ATC.

2. Markup over marginal cost

 Under monopolistic competition, P > MC.

 Under perfect competition, P = MC.

MONOPOLISTIC COMPETITION 11

Monopolistic Competition and Welfare

 Monopolistically competitive markets do not

have all the desirable welfare properties of

perfectly competitive markets.

 Because P > MC, the market quantity is below

the socially efficient quantity.

 Yet, not easy for policymakers to fix this problem:

Firms earn zero profits, so cannot require them

to reduce prices.

MONOPOLISTIC COMPETITION 12

Monopolistic Competition and Welfare

 Number of firms in the market may not be optimal,

due to external effects from the entry of new firms:

 The product-variety externality:

surplus consumers get from the introduction

of new products

 The business-stealing externality:

losses incurred by existing firms

when new firms enter market

 The inefficiencies of monopolistic competition are

subtle and hard to measure. No easy way for

policymakers to improve the market outcome.

1. So far, we have studied three market

structures: perfect competition, monopoly, and

monopolistic competition. In each of these,

would you expect to see firms spending money

to advertise their products? Why or why not?

2. Is advertising good or bad from society’s

viewpoint? Try to think of at least one “pro”

and “con.”

A C T I V E L E A R N I N G 1

Advertising

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MONOPOLISTIC COMPETITION 14

Advertising

 In monopolistically competitive industries,

product differentiation and markup pricing

lead naturally to the use of advertising.

 In general, the more differentiated the products,

the more advertising firms buy.

 Economists disagree about the social value of

advertising.

MONOPOLISTIC COMPETITION 15

The Critique of Advertising

 Critics of advertising believe:

 Society is wasting the resources it devotes to

advertising.

 Firms advertise to manipulate people’s tastes.

 Advertising impedes competition –

it creates the perception that products are

more differentiated than they really are,

allowing higher markups.

MONOPOLISTIC COMPETITION 16

The Defense of Advertising

 Defenders of advertising believe:

 It provides useful information to buyers.

 Informed buyers can more easily find and

exploit price differences.

 Thus, advertising promotes competition and

reduces market power.

 Results of a prominent study:

Eyeglasses were more expensive in states

that prohibited advertising by eyeglass makers

than in states that did not restrict such advertising.

MONOPOLISTIC COMPETITION 17

Advertising as a Signal of Quality

A firm’s willingness to spend huge amounts

on advertising may signal the quality of its product

to consumers, regardless of the content of ads.

 Ads may convince buyers to try a product once,

but the product must be of high quality for people

to become repeat buyers.

 The most expensive ads are not worthwhile

unless they lead to repeat buyers.

 When consumers see expensive ads,

they think the product must be good if the company

is willing to spend so much on advertising.

MONOPOLISTIC COMPETITION 18

Brand Names

 In many markets, brand name products coexist

with generic ones.

 Firms with brand names usually spend more on

advertising, charge higher prices for the products.

 As with advertising, there is disagreement about

the economics of brand names…

MONOPOLISTIC COMPETITION 19

The Critique of Brand Names

 Critics of brand names believe:

 Brand names cause consumers to perceive

differences that do not really exist.

 Consumers’ willingness to pay more for brand

names is irrational, fostered by advertising.

 Eliminating govt protection of trademarks

would reduce influence of brand names,

result in lower prices.

MONOPOLISTIC COMPETITION 20

The Defense of Brand Names

 Defenders of brand names believe:

 Brand names provide information about quality

to consumers.

 Companies with brand names have incentive

to maintain quality, to protect the reputation of

their brand names.

MONOPOLISTIC COMPETITION 21

CONCLUSION

 Differentiated products are everywhere;

examples of monopolistic competition abound.

 The theory of monopolistic competition describes

many markets in the economy,

yet offers little guidance to policymakers looking

to improve the market’s allocation of resources.

CHAPTER SUMMARY

 A monopolistically competitive market has

many firms, differentiated products, and free entry.

 Each firm in a monopolistically competitive market

has excess capacity – produces less than the

quantity that minimizes ATC. Each firm charges a

price above marginal cost.

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CHAPTER SUMMARY

 Monopolistic competition does not have all of the

desirable welfare properties of perfect competition.

There is a deadweight loss caused by the markup

of price over marginal cost. Also, the number of

firms (and thus varieties) can be too large or too

small. There is no clear way for policymakers to

improve the market outcome.

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CHAPTER SUMMARY

 Product differentiation and markup pricing lead to

the use of advertising and brand names. Critics of

advertising and brand names argue that firms use

them to reduce competition and take advantage of

consumer irrationality. Defenders argue that firms

use them to inform consumers and to compete

more vigorously on price and product quality.

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