LESSON #03A

MARKET STRUCTURE - MONOPOLISTIC COMPETITION

ECON676 ECONOMIC ANALYSIS
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 Lesson Outline
Introduction
Characteristics of Monopolistic Competition

Short-Run Output and Price

Long-Run Output and Price

Monopolistic Competition & Economic Efficiency

Advertising

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Market Structure
Characteristics of Different Market Types:
Market Number of Type of Power of Firm Barriers to Non-Price
Structure Firms Product Over Price Entry Competition

Perfect None
Many Homogeneous Very Low None
Competition (Price Taker)

Advertising
Monopolistic
Many Differentiated Some Low and Product
Competition
Differentiation
Homogeneous Advertising
Some or
Oligopoly Few or High and Product
Considerable
Differentiated Differentiation

Unique
Monopoly One Considerable Very high Advertising
products
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 Introduction
This is the third topic in our analysis of market
structures.
As the name suggests, monopolistic competition
combines elements of monopoly and competition
Examples:
Travel agencies / maid agencies
Hair dressers
Service stations
Dry cleaners
Pizzeria

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 Characteristics

There are four general characteristics of

monopolistic competition:
1. there are a large number of firms
2. each firms product is slightly different
3. freedom of entry/exit
4. firms engage in non-price competition

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 Characteristics
1. Large Number of Firms
The number of firms is large => low concentration ratio
industries
Each firm is small enough to expect that its actions will go
unnoticed by its competitors
So:
No mutual interdependence
No collusion
Thus, each is an independent decision-maker
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 Characteristics
2. Product Differentiation
i. Each firms product is slightly different
This is a fundamental difference to perfect competition a
perfectly competitive firms product would be identical to
the products of other firms.
ii. Product differences can be due to a number of
factors
They can be real: features, material, design, or
workmanship
Or, imaginary: advertising, packaging, trademarks
They can also be due to: location, attitude, reputation
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 Characteristics
2. Product Differentiation (contd)
iii. Each firm faces competition from close, but not
perfect substitutes
This is extremely important because:
Each firm has a very elastic demand curve (but not
perfectly elastic as with perfect competition)
Each firm also possesses some market power (i.e.
differentiated products)

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 Characteristics
2. Product Differentiation (contd)
iii. Each firm faces competition from close, but not
perfect substitutes
Therefore, firms demand curves slope (gently) downwards:

Note:
Firms use the associated MR
curve to determine price and
output.

This is the monopolistic aspect of

monopolistic competition.
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 Characteristics
Consider Price Changes
(a) Perfect Competition (b) Monopolistic Competition
Firms can only charge the There is no such thing as the
market rate market price, because firms
are not selling identical
products.

That is, charge more (P) and Increase P (P) lose sales,
they will sell nothing but not all of them.

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 Characteristics
3. Freedom of Entry and Exit
Relatively easy because of small size of firms
Limited economies of scale
No significant capital requirements

In the long-run, no monopolistically competitive firm is

able to do much better than earn a normal profit.

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 Characteristics
4. Existence of Non-Price Competition
Since each firm produces a similar, but somewhat
different product, there is an incentive for each firm to
play on this difference in order to boost sales.
This is known as non-price competition
So, the behaviour of monopolistically competitive firms is
to differentiate their products How does this compare
which leads to more profit with perfect competition?

which in turn induces entry of new firms

so differentiate the products again
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 Short-Run Output and Price
The short run equilibrium position of a monopolistically
competitive firm looks just like that of a monopolist
The difference is that there are many firms, unlike just one in a
monopoly
Example: Consider two typical firms (monopolistically
competitive) in the same industry. Assume:
Profit-maximizing behaviour (i.e. set MR=MC)
Firm A effectively differentiate its product it captures a large
part of demand
Firm B does not improve its product: it doesnt advertise, or its
advertising becomes tired loses a large part of demand
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 Short-Run Output and Price

Firm A Firm B
P P

AC

AC

P*
P*

Q* Q Q* Q
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 Short-Run Output and Price

Summary:

Short-run profit and loss can be sustained (due

to differentiation)

Product differentiation and promotion are

extremely important

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 Long-Run Output and Price

For a monopolist, above normal profit could be

sustained in the long run.
For a monopolistically competitive firm, short-run profit
induces entry of new firms:
Entry is easy: similar products and no barriers
As new firms enter:
demand curve shifts to the left
demand curve becomes more price-elastic because the firm
has smaller market and more substitutes

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 Long-Run Output and Price
P
AC
MC

D
MR

Q
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Economic Profit
 Long-Run Output and Price
P
AC
MC

D
MR

Q
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Economic Profit
 Long-Run Output and Price
P
AC
MC

D
MR

Economic Profit Q
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 Long-Run Output and Price AC
P MC

D
MR

Q
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Economic Loss
 Long-Run Output and Price AC
P MC

D
MR

Q
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Economic Loss
 Long-Run Output and Price AC
P MC

D
MR

Q
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Economic Loss
 Long-Run Output and Price

This process continues until

firms earn only normal P

profits or zero economic

profits.
At this point, there is no AC

further incentive for other P*

firms to enter the industry.

Q* Q
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Monopolistic Competition & Economic Efficiency

Let's examine monopolistic competition from the following

perspectives:
Productive efficiency: min ATC
Allocative efficiency: P = MC
These qualities imply that consumers enjoy the largest
volume at the lowest price, subject to prevailing
conditions.
Both are achieved with perfect competition
Neither is achieved with monopolistic competition
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Monopolistic Competition & Economic Efficiency

Monopolistic Competition and Perfect Competition

Two key differences between monopolistic competition
and perfect competition are:
Excess capacity
A firm has excess capacity if it produces less than the
quantity at which ATC is a minimum. [Note: It is said to be over-
utilizing capacity if it produces on the upward-sloping part of the ATC
curve.]

Markup
A firms markup is the amount by which its price exceeds its
marginal cost.
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Monopolistic Competition & Economic Efficiency
P

PMC

Operating
at Capacity

QMC Q

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Monopolistic Competition & Economic Efficiency

1. Productive Efficiency
at (PMC, QMC), excess capacity is said to exist
Monopolistic competition is productively inefficient
because:
Too many firms are producing too little
If firms used their idle (excess) capacity, we could have
less firms:
Same output
Lower ATC
Less corner stores
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Monopolistic Competition & Economic Efficiency

2. Allocative Efficiency
at (PMC, QMC), P>MC price markup
P
Under monopolistic competition,
there are consumers willing to
pay a price for the product that DWL

exceeds MC of producing it, but

who are unable to buy it at such PMC

a price.
Deadweight loss (DWL)
QMC Q
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Monopolistic Competition & Economic Efficiency
Monopolistic Competition Perfect Competition
P P

PMC
PC

QMC Q QC Q

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Monopolistic Competition & Economic Efficiency

In the above comparison, monopolistic competition

appears to be a less desirable market structure than
perfect competition.
o In the long run, no more than a normal profit is earned.
o Demand is highly elastic so the price-output outcome is close
to the perfect competition outcome.
But under monopolistic competition, the consumers get a
greater variety of products, in the form of:
Quality (types / styles / brands)
Service
Information and other forms of non-price competition
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 Advertising
Firms with market power, like monopolistically
competitive firms, can create and capture surplus with
non-price strategies, such as by choosing the amount of
advertising for its product.
By advertising, a seller hopes to increase the demand
for its product, shifting the demand curve rightward and
creating more surplus in the market.
However, the firm must also recognize that advertising
is costly.
Only by correctly choosing the level of advertising can
the firm capture as much surplus as possible.
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 Advertising
EFFECTS OF ADVERTISING

AR and MR are average and

marginal revenue when the firm
doesnt advertise,
and AC and MC are average
and marginal cost.
The firm produces Q0 and
receives a price P0.
Its total profit 0 is given by
the gray-shaded rectangle.

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 Advertising
EFFECTS OF ADVERTISING
If the firm advertises, its
average and marginal revenue
curves shift to the right.
Average cost rises (to AC) but
marginal cost remains the same.
The firm now produces Q1
(where MR = MC), and
receives a price P1.
Its total profit, 1, is now
larger.

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 End of Module

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