Diploma in Management Studies

Microeconomics ECO001
Lecture 10 Monopolistic Competition
Topics to be discussed:
Features of Monopolistic Competition
Short Run Equilibrium in Monopolistic Competition
Long run Equilibrium in Monopolistic Competition
Comparison Between Monopolistic Competition and
Perfect Competition
Effect of Advertising and Innovation
Ref: Parkin, Chapter 14
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Learning Outcomes
After this lecture, students should be able to:
Define and identify monopolistic competition
Explain how output and price are determined
in a monopolistically competitive industry
Compare between monopolistic competition
and perfect competition
Explain why advertising costs are high in a
monopolistically competitive industry
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Features of 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.

Example: Retail industry

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Features of 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 firms actions directly affect
the actions of other firms.
Collusion, or conspiring to fix prices, is
impossible.
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Product Differentiation
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.

Competition with Product Differentiation

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.
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Short Run Equilibrium

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 set at the highest price the firm
can charge for the profit-maximizing
quantity.
The price is determined from the demand
curve for the firms product.
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Short Run Equilibrium

The figure shows a
short-run equilibrium
for a firm in
monopolistic
competition.
It operates much like a
single-price monopoly.

Price and Output Decision

The firm produces the
quantity at which
marginal revenue
equals marginal cost
and sells that quantity
for the highest
possible price.
It makes an economic
profit (as in this
example) when P >
ATC.
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Loss Minimizing
A firm might incur an
economic loss in the
short run.
P < ATC
It will operate in the
short run if P > AVC
It will shut down in the
short run if P < AVC

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Long Run Equilibrium

Long Run: Zero Economic Profit
In the long run, economic profit induces
entry.
And entry continues as long as firms in the
industry make an economic profitas 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.
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Long Run Equilibrium

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.
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Long Run Equilibrium

The figure shows a
firm in monopolistic
competition in longrun equilibrium.
If firms incur an
economic loss, firms
exit to achieve the
long-run equilibrium.

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Monopolistic Competition and

Perfect Competition
Two key differences between monopolistic
competition and perfect competition are:
Excess capacity
Markup
A firm has excess capacity if it produces less
than the quantity at which ATC is a minimum.
A firms markup is the amount by which its
price exceeds its marginal cost.

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Excess Capacity
Firms in monopolistic
competition operate
with excess capacity
in long-run
equilibrium.
The downwardsloping demand curve
for their products
drives this result.

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Markup
Firms in monopolistic
competition operate
with positive mark up.
Again, the downwardsloping demand curve
for their products
drives this result.

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Perfect Competition
In contrast, firms in
perfect competition
have no excess
capacity and no
markup.
The perfectly elastic
demand curve for
their products drives
this result.
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Monopolistic Competition and

Efficiency
Is Monopolistic Competition Efficient?
Because in monopolistic competition P > MC,
marginal benefit exceeds marginal cost.
So monopolistic competition seems to be
inefficient.
But the markup of price above marginal cost
arises from product differentiation.
People value variety but variety is costly.
Monopolistic competition brings the profitable
and possibly efficient amount of variety to
market.
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Product Development and Marketing

Innovation and Product Development
Weve looked at a firms profit-maximizing
output decision in the short run and the long
run of a given product and with given
marketing effort.
To keep making 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.
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Product Innovation
Innovation is costly, but it increases total
revenue.
Profit will increase if total revenue increases
by more than total cost
Firms pursue product development until the
marginal revenue from innovation equals the
marginal cost of innovation inn order to
maximize profit.

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Exercise 10.1
Of the following characteristics, which one
applies exclusively to a monopolistic
competitive firm?

A) It always earns a profit.

B) It produce differentiated product.

C) It can sell all it wants to at the

market price.

D) It has no barriers to entry.

E) It has a range of prices it can

charge for its output.
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Answers to Exercise 10.1

The correct answer is (B).
Monopolistic competitive firm competes
from each other by differentiating their
products so that each firm can have
some market power.

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Exercise 10.2
The similarity between monopoly and
monopolistic competition is:
(a) There are barriers to entry
(b) They sell differentiated product
(c) There is perfect information
(d) There is long run normal profit
(e) The price is higher than marginal
revenue
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Answers to Exercise 10.2

The correct answer is (e).
For monopoly and monopolistic competition,
the demand curve is downward sloping and
so marginal revenue curve is below the
demand curve.
To sell one more unit the firms need to
charge a lower price for all units.
Thus price is larger than marginal revenue
for both market structures.
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Exercise 10.3
The similarity between perfect competition
and monopolistic competition in the long
run is:
(a) They both produces at the lowest point
of the ATC
(b) They both charge a price equals
marginal cost
(c) They both earn normal profit
(d) The number of firms are the same
(e) Firms demand curve is horizontal
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Answers to Exercise 10.3

The correct answer is (c).
There is free entry and exit of firms in
perfect competition and monopolistic
competition. In the long run
Profits will induce more firms to enter the
industry and push down prices
Loss will lead to firms leaving the industry
and push up prices
All firms earn zero economic profit in the
long run.
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Exercise 10.4
(a) Consider a monopolistic competitive
firm selling shoes and make a normal
profit. How can it differentiate its product
in order to make economic profit?
(b) If the firm is able to differentiate
successfully and earns an economic profit
in the short run. What will happen to this
firm in the long run?
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Answers to Exercise 10.4

(a) The firm can differentiate its product by:
(1) Changing the shapes, sizes, cutting,
colours of the shoes
(2) Provide quality service and after sales
services
(3) Innovate and provide better quality
shoes
(4) Produce at a low cost and charge a low
price
(5) Advertise vigorously
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Answers to Exercise 10.4 (b)

Due to free entry and exit, in the long run
more new firms attracted by the profit will
enter the industry.
Each new firm produces a differentiated
product, thus provides more substitutes in
the market and take away existing firms
customers.
Existing firms demand curve shifts
leftwards and becomes flatter until all
firms can only break even in the long run.

Monopolistic Competition
Short Run Profit

Long Run Normal Profit

P

P
MC

MC

ATC

P1

ATC

P2
D
MR
Q1

MR

D
Q

Q2

Exercise 10.5
1. What are the effects of advertising in the
monopolistic competitive market?
2. Draw the diagram of a monopolistic
competitive firm that is earning an economic
profit. Be sure to label all the curves. Indicate
the area that equals the firms economic
profit. Is this a long-run equilibrium? Why or
why not?
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Answers to Exercise 10.5

1. Advertising increases cost to the firm and
hence raises the ATC curve.
It may also create awareness of the firms
product so that demand and marginal revenue
increases and the firm can charge higher price
The firm may earn higher profit in the short run
if the effect on price exceeds cost.
In the long run, all firms advertise and thus
demand becomes more elastic, price drops
until no more profit for each firm.
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 2. Please draw a downward sloping

demand curve, a downward sloping
MR curve, a U-shaped ATC curve
and a U-shaped MC curve which
intersects the ATC curve at the
lowest point of ATC curve.

This is a short run equilibrium,

not a long run equilibrium. In the
long run equilibrium, all firms earn
zero profit.

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