Monopolistic competition

From Wikipedia, the free encyclopedia

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a
quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a
price based on the average revenue (AR) curve. The difference between the firm's average revenue and
average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost
and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the
market and increased competition. The firm no longer sells its goods above average cost and can no longer
claim an economic profit

Economics
 A supply and demand diagram, illustrating
the effects of an increase in demand.

 Index

 Outline

 Category

 History

 Types

 Classification

 History of economics
 Economic history (academic study)
 Schools of economics
 Microeconomics
 Macroeconomics
 Methodology
 Heterodox economics
 JEL classification codes

 Concepts

 Theory

 Techniques

 Econometrics
 Economic growth
 Economic system
 Experimental economics
 Mathematical economics
 Game theory
 Post-scarcity
 Market
  National accounting

By application

 Agricultural
 Behavioral
 Business
 Computational
 Cultural
 Demographic
 Development
 Digitization
 Ecological
 Education
 Engineering
 Environmental
 Evolutionary
 Expeditionary
 Geography
 Health
 Industrial organization
 Information
 International
 Knowledge
 Labour
 Law
 Managerial
 Monetary / Financial
 Natural resource
 Organizational
 Personnel
 Public / Welfare economics
 Regional
 Rural
 Service
 Social
 Urban
 Welfare
 Lists

 Economists
 Publications (journals)

Glossary

 Glossary of economics

 Business and economics portal

 v
 t
 e

Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another (e.g. by branding or quality) and hence are not
perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given
and ignores the impact of its own prices on the prices of other firms.[1][2] In the presence of coercive
government, monopolistic competition will fall into government-granted monopoly. Unlike perfect
competition, the firm maintains spare capacity. Models of monopolistic competition are often used to
model industries. Textbook examples of industries with market structures similar to monopolistic
competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The
"founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who
wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933).[3] Joan
Robinson published a book The Economics of Imperfect Competition with a comparable theme of
distinguishing perfect from imperfect competition.
Monopolistically competitive markets have the following characteristics:

 There are many producers and many consumers in the market, and no business has total
control over the market price.

 Consumers perceive that there are non-price differences among the competitors' products.

 There are few barriers to entry and exit.[4]

 Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost the same as a
perfectly competitive market. Two differences between the two are that monopolistic competition
produces heterogeneous products and that monopolistic competition involves a great deal of non-
price competition, which is based on subtle product differentiation. A firm making profits in the short
run will nonetheless only break even in the long run because demand will decrease and average
total cost will increase. This means in the long run, a monopolistically competitive firm will make
zero economic profit. This illustrates the amount of influence the firm has over the market; because
of brand loyalty, it can raise its prices without losing all of its customers. This means that an
individual firm's demand curve is downward sloping, in contrast to perfect competition, which has
a perfectly elastic demand schedule.

Contents
 [hide]

 1Characteristics of monopolistic competition

o 1.1Product Differentiation
o 1.2Many firms
o 1.3Freedom of Entry and Exit
o 1.4Independent decision making
o 1.5Market power
o 1.6Imperfect information
 2Inefficiency
o 2.1Socially undesirable aspects compared to perfect competition
 3Problems
 4Examples
 5See also
 6Notes
 7External links

Characteristics of monopolistic competition[edit]

There are six characteristics of monopolistic competition (MC):

 Product differentiation
 Many firms
 Freedom of Entry and Exit
 Independent decision making
 Some degree of market power
 Buyers and sellers do not have perfect information (Imperfect Information)[5][6]
Product Differentiation[edit]
MC firms sell products that have real or perceived non-price differences. However, the differences
are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of
demand between goods in such a market is positive. In fact, the XED would be high.[7] MC goods are
best described as close but imperfect substitutes.[7] The goods perform the same basic functions but
have differences in qualities such as type, style, quality, reputation, appearance, and location that
tend to distinguish them from each other. For example, the basic function of motor vehicles is the
same—to move people and objects from point to point in reasonable comfort and safety. Yet there
are many different types of motor vehicles such as motor scooters, motor cycles, trucks and cars,
and many variations even within these categories.
Many firms[edit]
There are many firms in each MC product group and many firms on the side lines prepared to enter
the market. A product group is a "collection of similar products".[8] The fact that there are "many
firms" gives each MC firm the freedom to set prices without engaging in strategic decision making
regarding the prices of other firms and each firm's actions have a negligible impact on the market.
For example, a firm could cut prices and increase sales without fear that its actions will prompt
retaliatory responses from competitors.
How many firms will an MC market structure support at market equilibrium? The answer depends on
factors such as fixed costs, economies of scale and the degree of product differentiation. For
example, the higher the fixed costs, the fewer firms the market will support.[9]
Freedom of Entry and Exit[edit]
Like perfect competition, under monopolistic competition also, the firms can enter or exit freely. The
firms will enter when the existing firms are making super-normal profits. With the entry of new firms,
the supply would increase which would reduce the price and hence the existing firms will be left only
with normal profits. Similarly, if the existing firms are sustaining losses, some of the marginal firms
will exit. It will reduce the supply due to which price would rise and the existing firms will be left only
with normal profit.
Independent decision making[edit]
Each MC firm independently sets the terms of exchange for its product.[10] The firm gives no
consideration to what effect its decision may have on competitors.[10]The theory is that any action will
have such a negligible effect on the overall market demand that an MC firm can act without fear of
prompting heightened competition. In other words, each firm feels free to set prices as if it were a
monopoly rather than an oligopoly.
Market power[edit]
MC firms have some degree of market power. Market power means that the firm has control over the
terms and conditions of exchange. An MC firm can raise its prices without losing all its customers.
The firm can also lower prices without triggering a potentially ruinous price war with competitors. The
source of an MC firm's market power is not barriers to entry since they are low. Rather, an MC firm
has market power because it has relatively few competitors, those competitors do not engage in
strategic decision making and the firms sells differentiated product.[11] Market power also means that
an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although
not "flat".
Imperfect information[edit]
No sellers or buyers have complete market information, like market demand or market supply.[12]

Market Structure comparison

Profit
Numb Mark Elasticit Product Pricin
Excess Efficien maximizati
er of et y of differentiati g
profits cy on
firms power demand on power
condition

Perfect Price
Perfectl P=MR=MC[
Competitio Infinite None None No Yes[13] 14] taker[14
y elastic ]
n

Monopolist Highly
ic elastic Yes/No Price
Many Low High[16] (Short/Long) No[18] MR=MC[14] setter[1
competitio (long [17] 4]
n run)[15]
 Relative Absolute Price
Monopoly One High ly (across Yes No MR=MC[14] setter[1
4]
inelastic industries)

Inefficiency[edit]
There are two sources of inefficiency in the MC market structure. First, at its optimum output the firm
charges a price that exceeds marginal costs, The MC firm maximizes profits where marginal
revenue = marginal cost. Since the MC firm's demand curve is downward sloping this means that the
firm will be charging a price that exceeds marginal costs. The monopoly power possessed by a MC
firm means that at its profit maximizing level of production there will be a net loss of consumer (and
producer) surplus. The second source of inefficiency is the fact that MC firms operate with excess
capacity. That is, the MC firm's profit maximizing output is less than the output associated with
minimum average cost. Both a PC and MC firm will operate at a point where demand or price equals
average cost. For a PC firm this equilibrium condition occurs where the perfectly elastic demand
curve equals minimum average cost. A MC firm’s demand curve is not flat but is downward sloping.
Thus in the long run the demand curve will be tangential to the long run average cost curve at a
point to the left of its minimum. The result is excess capacity.[19]
Socially undesirable aspects compared to perfect competition [edit]

 Selling costs: Products under monopolistic competition are spending huge amounts on
advertising and publicity. Much of this expenditure is wasteful from the social point of view. The
producer can reduce the price of the product instead of spending on publicity.
 Excess Capacity: Under Imperfect competition, the installed capacity of every firm is large, but
not fully utilized. Total output is, therefore, less than the output which is socially desirable. Since
production capacity is not fully utilized, the resources lie idle. Therefore, the production under
monopolistic competition is below the full capacity level.
 Unemployment: Idle capacity under monopolistic competition expenditure leads to
unemployment. In particular, unemployment of workers leads to poverty and misery in the
society. If idle capacity is fully used, the problem of unemployment can be solved to some
extent.
 Cross Transport: Under monopolistic competition expenditure is incurred on cross
transportation. If the goods are sold locally, wasteful expenditure on cross transport could be
avoided.
 Lack of Specialization: Under monopolistic competition, there is little scope for specialization or
standardization. Product differentiation practiced under this competition leads to wasteful
expenditure. It is argued that instead of producing too many similar products, only a few
standardized products may be produced. This would ensure better allocation of resources and
would promote economic welfare of the society.
 Inefficiency: Under perfect competition, an inefficient firm is thrown out of the industry. But under
monopolistic competition inefficient firms continue to survive.

Problems[edit]
Monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating
prices for products sold in monopolistic competition exceed the benefits of such regulation.[citation needed] .
A monopolistically competitive firm might be said to be marginally inefficient because the firm
produces at an output where average total cost is not a minimum. A monopolistically competitive
market is productively inefficient market structure because marginal cost is less than price in the
 long run. Monopolistically competitive markets are also allocatively inefficient, as the price given is
higher than Marginal cost. Product differentiation increases total utility by better meeting people's
wants than homogenous products in a perfectly competitive market.[citation needed]
Another concern is that monopolistic competition fosters advertising and the creation of brand
names. Advertising induces customers into spending more on products because of the name
associated with them rather than because of rational factors. Defenders of advertising dispute this,
arguing that brand names can represent a guarantee of quality and that advertising helps reduce the
cost to consumers of weighing the tradeoffs of numerous competing brands. There are unique
information and information processing costs associated with selecting a brand in a monopolistically
competitive environment. In a monopoly market, the consumer is faced with a single brand, making
information gathering relatively inexpensive. In a perfectly competitive industry, the consumer is
faced with many brands, but because the brands are virtually identical information gathering is also
relatively inexpensive. In a monopolistically competitive market, the consumer must collect and
process information on a large number of different brands to be able to select the best of them. In
many cases, the cost of gathering information necessary to selecting the best brand can exceed the
benefit of consuming the best brand instead of a randomly selected brand. The result is that the
consumer is confused. Some brands gain prestige value and can extract an additional price for that.
Evidence suggests that consumers use information obtained from advertising not only to assess the
single brand advertised, but also to infer the possible existence of brands that the consumer has,
heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the
advertised brand.[20]

Examples[edit]
In many markets, such as toothpaste, soap, air conditioning, smartphones and toilet paper,
producers practice product differentiation by altering the physical composition of products, using
special packaging, or simply claiming to have superior products based on brand
images or advertising.[citation needed]

See also[edit]

 Economics portal

 Atomistic market
 Government-granted monopoly
 Imperfect competition
 Microeconomics
 Monopolistic competition in international trade
 Monopoly
 Natural monopoly
 Oligopoly
 Perfect competition

Notes[edit]
1. Jump up^ Krugman, Paul; Obstfeld, Maurice (2008). International Economics: Theory and Policy.
Addison-Wesley. ISBN 0-321-55398-5.
2. Jump up^ Poiesz, Theo B. C. (2004). "The Free Market Illusion Psychological Limitations of
Consumer Choice" (PDF). Tijdschrift voor Economie en Management. 49(2): 309–338.
 3. Jump up^ "Monopolistic Competition". Encyclopædia Britannica.
4. Jump up^ Gans, Joshua; King, Stephen; Stonecash, Robin; Mankiw, N. Gregory (2003). Principles of
Economics. Thomson Learning. ISBN 0-17-011441-4.
5. Jump up^ Goodwin, N.; Nelson, J.; Ackerman, F.; Weisskopf, T. (2009). Microeconomics in
Context (2nd ed.). Sharpe. p. 317. ISBN 978-0-7656-2301-0.
6. Jump up^ Hirschey, M. (2000). Managerial Economics (Rev. ed.). Fort Worth: Dryden.
p. 443. ISBN 0-03-025649-6.
7. ^ Jump up to:a b Krugman; Wells (2009). Microeconomics (2nd ed.). New York: Worth. ISBN 978-0-
7167-7159-3.
8. Jump up^ Samuelson, W.; Marks, S. (2003). Managerial Economics (4th ed.). Wiley. p. 379. ISBN 0-
470-00044-9.
9. Jump up^ Perloff, J. (2008). Microeconomics Theory & Applications with Calculus. Boston: Pearson.
p. 485. ISBN 978-0-321-27794-7.
10. ^ Jump up to:a b Colander, David C. (2008). Microeconomics (7th ed.). New York: McGraw-Hill/Irwin.
p. 283. ISBN 978-0-07-334365-5.
11. Jump up^ Perloff, J. (2008). Microeconomics Theory & Applications with Calculus. Boston: Pearson.
p. 483. ISBN 978-0-321-27794-7.
12. Jump up^ Goodwin, N.; Nelson, J.; Ackerman, F.; Weisskopf, T. (2009). Microeconomics in
Context (2nd ed.). Sharpe. p. 289. ISBN 978-0-7656-2301-0.
13. Jump up^ Ayers, R.; Collinge, R. (2003). Microeconomics: Explore & Apply. Pearson. pp. 224–
225. ISBN 0-13-177714-9.
14. ^ Jump up to:a b c d e f Perloff, J. (2008). Microeconomics Theory & Applications with Calculus. Boston:
Pearson. p. 445. ISBN 978-0-321-27794-7.
15. Jump up^ Ayers, R.; Collinge, R. (2003). Microeconomics: Explore & Apply. Pearson. p. 280. ISBN 0-
13-177714-9.
16. Jump up^ Pindyck, R.; Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall.
p. 424. ISBN 0-13-030472-7.
17. Jump up^ Pindyck, R.; Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall.
p. 425. ISBN 0-13-030472-7.
18. Jump up^ Pindyck, R.; Rubinfeld, D. (2001). Microeconomics (5th ed.). London: Prentice-Hall.
p. 427. ISBN 0-13-030472-7.
19. Jump up^ The firm has not reached full capacity or minimum efficient scale. Minimum efficient scale
is the level of production at which the long run average cost curve first reaches its minimum. It is the
point where the LRATC curve "begins to bottom out." Perloff, J. (2008). Microeconomics Theory &
Applications with Calculus. Boston: Pearson. pp. 483–484. ISBN 978-0-321-27794-7.
20. Jump up^ Antony Davies & Thomas Cline (2005). "A Consumer Behavior Approach to Modeling
Monopolistic Competition". Journal of Economic Psychology. 26 (6): 797–
826. doi:10.1016/j.joep.2005.05.003.

External links

Monopolistic Competition – definition,

diagram and examples
Tejvan Pettinger February 27, 2017 markets

Definition: Monopolistic competition is a market structure which combines elements of

monopoly and competitive markets. Essentially a monopolistic competitive market is
one with freedom of entry and exit, but firms can differentiate their products. Therefore,
they have an inelastic demand curve and so they can set prices. However, because
there is freedom of entry, supernormal profits will encourage more firms to enter the
market leading to normal profits in the long term.
 A monopolistic competitive industry has the following features:

 Many firms.
 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers because the good is highly
differentiated
 Firms make normal profits in the long run but could make supernormal profits in the short term
 Firms are allocatively and productively inefficient.

Diagram monopolistic competition short run

In
the short run, the diagram for monopolistic competition is the same as for a monopoly.

The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to
supernormal profit

Monopolistic competition long run

 In the long-run, supernormal profit encourages new firms to enter. This reduces demand
for existing firms and leads to normal profit.

Efficiency of firms in monopolistic competition

 Allocative inefficient. The above diagrams show a price set above marginal cost
 Productive inefficiency. The above diagram shows a firm not producing on the lowest point of
AC curve
 Dynamic efficiency. This is possible as firms have profit to invest in research and development.
 X-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide
better products.

Examples of monopolistic competition

 Restaurants – restaurants compete on quality of food as much as price. Product differentiation
is a key element of the business. There are relatively low barriers to entry in setting up a new
restaurant.
 Hairdressers. A service which will give firms a reputation for the quality of their hair-cutting.
 Clothing. Designer label clothes are about the brand and product differentiation
 TV programmes – globalisation has increased the diversity of tv programmes from networks
around the world. Consumers can choose between domestic channels but also imports from
other countries and new services, such as Netflix.

Limitations of the model of monopolistic competition

 Some firms will be better at brand differentiation and therefore, in the real world, they will be
able to make supernormal profit.
 New firms will not be seen as a close substitute.
 There is considerable overlap with oligopoly – except the model of monopolistic competition
assumes no barriers to entry. In the real world, there are likely to be at least some barriers to
entry
 If a firm has strong brand loyalty and product differentiation – this itself becomes a barrier to
entry. A new firm can’t easily capture the brand loyalty.
 Many industries, we may describe as monopolistically competitive are very profitable, so the
assumption of normal profits is too simplistic.

Key difference with monopoly

In monopolistic competition there are no barriers to entry. Therefore in long run, the
market will be competitive, with firms making normal profit.

Key difference with perfect competition

In Monopolistic competition, firms do produce differentiated products, therefore, they are

not price takers (perfectly elastic demand). They have inelastic demand.

New trade theory and monopolistic competition

New trade theory places importance on the model of monopolistic competition for
explaining trends in trade patterns. New trade theory suggests that a key element of
product development is the drive for product differentiation – creating strong brands and
new features for products. Therefore, specialisation doesn’t need to be based on
traditional theories of comparative advantage, but we can have countries both importing
and exporting the same good. For example, we import Italian fashion labels and export
British fashion labels. To consumers, the importance is the choice of goods.

Readers Question: if all firms in a monopolistic competitive industry were to merge

would that firm produce as many different brands or just one brand?

Interesting question. I think it is an open-ended question with many different

possibilities. One approach is to think how firms in different industries may behave if
they did merge. Bearing in mind the model of monopolistic competition doesn’t always
stand up to scrutiny too well in the real world.
If the firms merged together, there is no certainty how they would behave.

In some industries, it makes sense to have many differentiated brands creating an

illusion of competition and providing a barrier to entry.

How many soap powders are there? About 35. But, most of these brands are owned by
two companies, Unilever and Proctor and Gamble. Having brand proliferation means it
is harder for a new firm to enter the market. This is because a new firm would have to
compete against 30 established brands as opposed to 2. There is less chance of getting
a good market share with so many brands. Therefore the new firm would have an
incentive to keep different brands to deter competitors.

However, if you have merge different brands there may be economies of scale. You can
devote more resources and investment to improving that particular product and
maximising its efficiency. This might be appropriate for an industry like computer
software or computers. There used to be many different brands of computers until the
pc came to dominate.

Are the different brands catering to different sectors of the market. If you take the
restaurant business, there is a big difference between Chinese and Indian. If 2
restaurants merge, they would be better off retaining distinct business. It would make no
sense to have a restaurant which offered a mixture of Chinese/Indian – consumers
would trust it less.

If you fear the arrival of a powerful company, it might be good to consolidate your
brands. For example, there are many small search engines, but they would be better off
combining forces to compete against the mighty Google.

Example of Monopolistic Competition

The athletic shoe market:

When you walk into a sports store to buy running shoes, you will find a number of brands, like Nike,
Adidas, New Balance, ASICS, etc.

i. On one hand, the market for running shoes seems to be full of competition, with thousands of
competing brands and low barriers to entry.
ii. On the other hand, its market seems to be monopolistic, due to uniqueness of each shoe brand and
power to charge different price.

Characteristics of Monopolistic Competition

1. Product Differentiation
Products are differentiated (based on things like service, quality or design). The product of a firm is
close, but not perfect substitute of other firm. This gives some monopoly power to an individual firm
to influence market price of its product.

2. Barriers to Entry
There are no barriers to entry. It ensures that there are neither supernormal profits nor any
supernormal losses to a firm in the long run.

3. Number of Sellers
There are large numbers of firms selling closely related, but not homogeneous products. Each firm
acts independently and has a limited share of the market. So, an individual firm has limited control
over the market price.

4. Marketing
Products are differentiated and these differences are made known to the buyers through
advertisement and promotion. These costs constitute a substantial part of the total cost under
monopolistic competition.

5. Perfect Knowledge
There is imperfect knowledge in the market. People don’t know who is selling the good the cheapest
or who has the best quality. Sometimes a higher priced product is preferred even though it is of
inferior quality.

Monopolistic Competition: Short & Long Run

Equilibrium
The diagram is the same as monopolies. The firm has the same short and long equilibrium and
makes zero economic profits. Using the Profit Maximization Rule, MC = MR, we can find the
quantity and draw a vertical line to the Demand curve, and thus find the corresponding price. The
cost is found by drawing a vertical line from where Quantity meets the Average Cost curve to the
price line.
Any signs of supernormal profits would create an incentive for more firms to enter the market, and
since there are no barriers to entry, companies will join to make supernormal profits. This process
will continue till everyone makes normal or zero economic profits in the long run. Even though
normal profits are break-even, it includes profits for the entrepreneur for taking on risk.

Even though there is allocative inefficiency (where Price exceeds Marginal Cost) in monopolistic
competition, there is a greater variety of products for the customer to select. However, costs rise
because firms are forced to spend money on advertising.

Short & Long Run

Equilibrium
Share
Tweet
Share

Email
+1
Reddit
PREV POST
Liquidity Preference Theory
 Monopolistic Competition: Short-Run Profits and
Losses, and Long-Run Equilibrium

Monopolistic competition is the economic market model with

many sellers selling similar, but not identical, products.
The demand curve of monopolistic competition is elastic because
although the firms are selling differentiated products, many are still
close substitutes, so if one firm raises its price too high, many of its
customers will switch to products made by other firms.
This elasticity of demand makes it similar to pure competition
where elasticity is perfect. Demand is not perfectly elastic because
a monopolistic competitor has fewer rivals then would be the case
for perfect competition, and because the products are differentiated
to some degree, so they are not perfect substitutes.

Monopolistic competition has a downward sloping demand curve.

Thus, just as for a pure monopoly, its marginal revenue will always
be less than the market price, because it can only increase demand
by lowering prices, but by doing so, it must lower the prices of all
units of its product. Hence, monopolistically competitive firms
maximize profits or minimize losses by producing that quantity
where marginal revenue equals marginal cost, both over the short
run and the long run.

Short-Run Profit Or Loss

In the short run, a monopolistically competitive firm maximizes

profit or minimizes losses by producing that quantity that
corresponds to when marginal revenue = marginal cost.
If average total cost is below the market price, then the firm will
earn an economic profit.
  D = Market Demand
 ATC = Average Total Cost
 MR = Marginal Revenue
 MC = Marginal Cost
As can be seen in this graph, the market price charged by the monopolistic competitive
firm is equal to the point on the demand curve where MR = MC.
Short-Run Profit = (Price - ATC) × Quantity

However, if the average total cost is above the market price, then
the firm will incur losses, equal to the average total cost minus the
market price multiplied by the quantity produced. It will still
minimize losses by producing that quantity where marginal
revenue equals marginal cost, but eventually the firm will either
have to reverse the losses, or it will have to exit the industry.
 Short-Run Loss = (ATC - Price) × Quantity

Long-Run Equilibrium: Normal Profits

If the competitive firms in an industry earn an economic profit,

then other firms will enter the same industry, which will reduce the
profits of the other firms. More firms will continue to enter the
industry until the firms are earning only a normal profit.

However, if there are too many firms, then firms will incur losses,
especially the inefficient ones, which will cause them to leave the
industry. Consequently, the remaining firms will return to normal
profitability. Hence, the long-run equilibrium for monopolistic
competition will equate the market price to the average total cost,
where marginal revenue equals marginal cost, as shown in the
diagram below. Remember, in economics, average total cost
includes a normal profit.
 Note that where MC rises above MR, the firm would incur greater costs than it would
receive in additional revenue, which is why the firm maximizes its profit by producing only
that quantity where MR = MC, and charging the price at 1.
2 Market Price = Marginal Cost = Allocative Efficiency
3 Productive Efficiency = Minimum ATC

Excess Capacity = Quantity Produced at Minimum ATC - Quantity that yields the
greatest profit (MR = MC).

Because monopolistically competitive firms do not operate at their

minimum average total cost, they, therefore, operate
with excess capacity. Note in the above diagram that firms
would lose money if they produced more to achieve either
allocative or productive efficiency. That most firms operate with
excess capacity is evident when looking at most monopolistically
competitive firms, such as restaurants and other retailers, where
salespeople are often idle.

In some cases, a firm will have enough of an advantage to continue

earning economic profits, even in the long run. For instance, a
business can have an excellent location relative to other locations
in the area, which will always give it an advantage over other firms
in that local market. Or a firm may have a patent or trademark on
its product that prevents competition. In such cases, firms have
some degree of market power that would allow them to price their
 products above competitors' prices without losing too much
business.

Productive And Allocative Efficiency Of Monopolistic Competition

Productive efficiency requires that:

Price = Minimum Average Total Cost

Pure competition can achieve productive efficiency, but most

monopolistic competitive firms do not, since they sell at a price
higher than the minimum average total cost, and would actually
lose money selling at their minimum ATC. To use their excess
capacity, they would have to produce a quantity equal to their
minimum ATC, but they would not be able to sell that amount
without lowering their prices, which would either reduce their
profits or actually incur losses.

The monopolistic firm also does not achieve allocative

efficiency. Allocative efficiencyrequires that:

Price = Marginal Cost

The monopolistic firm exhibits a downward sloping demand curve.

That means that in order to sell more units, it must lower its price,
but if it lowers its price, then it must lower its price on all of its
units. Thus, like a monopoly, marginal revenue continually
declines as quantity is increased. The firm maximizes profits when
marginal revenue = marginal cost, but this only occurs at a
quantity less than what a purely competitive firm would produce,
where marginal cost = market price. The marginal cost curve will
always intersect the marginal revenue curve before it intersects the
demand curve, because as previously stated, at any given quantity,
marginal revenue is always less than the market price. Because of
this allocative inefficiency, some consumers must forgo the
product because of its higher price.

While monopolistic competitive firms achieve neither productive

nor allocative efficiency, they do provide a variety of products.
The greater the differentiation of the products, the greater the
inefficiency. However, this greater diversity is more likely to
satisfy consumer tastes, which leads to a more desirable market.
 ◄ Previous Next ►
Monopolistic Competition Oligopoly

 Privacy Policy for thismatter.com

 Cookies are used to personalize content and ads, to provide social media features and
to analyze traffic. Information is also shared about your use of this site with our social
media, advertising and analytics partners. Details, including opt-out options, are
provided in the Privacy Policy.
 Send email to thismatter.com for suggestions and comments! Be sure to include the
words no spam in the subject. If you do not include the words, the email will be deleted
automatically.
 Information is provided 'as is' and solely for education, not for trading purposes or
professional advice.
 Copyright © 1982 - 2018 by William C. Spaulding
 Google+

Personal Finance
 Bankruptcy
 Credit and Debt
 Insurance
 Real Estate
 Taxes
 Wills, Estates, and Trusts
Investments
 Investment Fundamentals
 Investment Funds
 Banking
 Bonds
 Forex
 Futures
 Options
 Stocks
 Technical Analysis
 Economics

Contact Me!
 Press Alt + ` (Backtick) to Google search this site.
 Press Alt + 0 to display an outline of the above article.
  Press Alt + 1 to show only links in the above article.
 Press Ctrl + / to scroll to this detailed site menu.
 Click on any category link in the left column to display the Table of Contents for
that category in the right column.
 Click on a heading in the right column to expand or hide that section.

Credit, Debt, BankruptcyInsuranceReal EstateTaxWills,

Estates, and TrustsInvestment FundamentalsInvestment
Economics - Table
FundsBankingBondsDerivativesForexFuturesOptionsStocks of Contents
Technical AnalysisEconomics
► Fundamentals of
Economics
► Microeconomics

▼ Market Models:
Competition,
Oligopoly, and
Monopoly

Market Models: Pure

Competition, Monopolistic
Competition, Oligopoly, and
Pure MonopolyPure
CompetitionPure
Competition: Long-Run
EquilibriumPure
MonopolyPure Monopoly:
Demand, Revenue and Costs,
Price Determination, Profit
Maximization and Loss
MinimizationPrice
DiscriminationPure
Monopoly: Economic
EffectsMonopoly
RegulationMonopolistic
Competition

Monopolistic Competition:
Short-Run Profits and Losses,
and Long-Run
Equilibrium ◄ Current Docu
ment
 OligopolyGame Theory of
Oligopolistic Pricing
StrategiesOligopoly Pricing
Models

► Economic Resources

► Macroeconomics

10.1 Monopolistic Competition

Previous
Next
Learning Objectives

By the end of this section, you will be able to:

 Explain the significance of differentiated products

 Describe how a monopolistic competitor chooses price and quantity

 Discuss entry, exit, and efficiency as they pertain to monopolistic
competition
 Analyze how advertising can impact monopolistic competition
Monopolistic competition involves many firms competing against each
other, but selling products that are distinctive in some way. Examples
include stores that sell different styles of clothing; restaurants or grocery
stores that sell different kinds of food; and even products like golf balls or
beer that may be at least somewhat similar but differ in public perception
because of advertising and brand names. There are over 600,000
restaurants in the United States. When products are distinctive, each firm
has a mini-monopoly on its particular style or flavor or brand name.
However, firms producing such products must also compete with other
styles and flavors and brand names. The term “monopolistic competition”
captures this mixture of mini-monopoly and tough competition, and the
following Clear It Up feature introduces its derivation.

Who invented the theory of imperfect competition?

The theory of imperfect competition was developed by two economists
independently but simultaneously in 1933. The first was Edward
Chamberlin of Harvard University who published The Economics of
Monopolistic Competition. The second was Joan Robinson of Cambridge
University who published The Economics of Imperfect Competition.
Robinson subsequently became interested in macroeconomics where she
became a prominent Keynesian, and later a post-Keynesian economist. (See
the Welcome to Economics! and The Keynesian Perspective chapters for
more on Keynes.)

Differentiated Products
A firm can try to make its products different from those of its competitors
in several ways: physical aspects of the product, location from which the
product is sold, intangible aspects of the product, and perceptions of the
product. Products that are distinctive in one of these ways are
called differentiated products.
Physical aspects of a product include all the phrases you hear in
advertisements: unbreakable bottle, nonstick surface, freezer-to-
microwave, non-shrink, extra spicy, newly redesigned for your comfort. The
location of a firm can also create a difference between producers. For
example, a gas station located at a heavily traveled intersection can
probably sell more gas, because more cars drive by that corner. A supplier
to an automobile manufacturer may find that it is an advantage to locate
close to the car factory.
Intangible aspects can differentiate a product, too. Some intangible aspects
may be promises like a guarantee of satisfaction or money back, a
reputation for high quality, services like free delivery, or offering a loan to
purchase the product. Finally, product differentiation may occur in the
minds of buyers. For example, many people could not tell the difference in
taste between common varieties of beer or cigarettes if they were
blindfolded but, because of past habits and advertising, they have strong
preferences for certain brands. Advertising can play a role in shaping these
intangible preferences.
The concept of differentiated products is closely related to the degree of
variety that is available. If everyone in the economy wore only blue jeans,
ate only white bread, and drank only tap water, then the markets for
clothing, food, and drink would be much closer to perfectly competitive.
The variety of styles, flavors, locations, and characteristics creates product
differentiation and monopolistic competition.

Perceived Demand for a Monopolistic Competitor

A monopolistically competitive firm perceives a demand for its goods that is
an intermediate case between monopoly and competition. Figure 1 offers a
reminder that the demand curve as faced by a perfectly competitive firm
is perfectly elastic or flat, because the perfectly competitive firm can sell
any quantity it wishes at the prevailing market price. In contrast, the
demand curve, as faced by a monopolist, is the market demand curve, since
a monopolist is the only firm in the market, and hence is downward
sloping.
Figure 1. Perceived Demand for Firms in Different Competitive Settings. The demand curve
faced by a perfectly competitive firm is perfectly elastic, meaning it can sell all the output it
wishes at the prevailing market price. The demand curve faced by a monopoly is the market
demand. It can sell more output only by decreasing the price it charges. The demand curve faced
by a monopolistically competitive firm falls in between.
The demand curve as faced by a monopolistic competitor is not flat, but
rather downward-sloping, which means that the monopolistic competitor
can raise its price without losing all of its customers or lower the price and
gain more customers. Since there are substitutes, the demand curve facing
a monopolistically competitive firm is more elastic than that of a monopoly
where there are no close substitutes. If a monopolist raises its price, some
consumers will choose not to purchase its product—but they will then need
to buy a completely different product. However, when a monopolistic
competitor raises its price, some consumers will choose not to purchase the
product at all, but others will choose to buy a similar product from another
firm. If a monopolistic competitor raises its price, it will not lose as many
customers as would a perfectly competitive firm, but it will lose more
customers than would a monopoly that raised its prices.
At a glance, the demand curves faced by a monopoly and by a monopolistic
competitor look similar—that is, they both slope down. But the underlying
economic meaning of these perceived demand curves is different, because a
monopolist faces the market demand curve and a monopolistic competitor
does not. Rather, a monopolistically competitive firm’s demand curve is but
one of many firms that make up the “before” market demand curve. Are you
following? If so, how would you categorize the market for golf balls? Take a
swing, then see the following Clear It Up feature.
Are golf balls really differentiated products?
Monopolistic competition refers to an industry that has more than a few
firms, each offering a product which, from the consumer’s perspective, is
different from its competitors. The U.S. Golf Association runs a laboratory
that tests 20,000 golf balls a year. There are strict rules for what makes a
golf ball legal. The weight of a golf ball cannot exceed 1.620 ounces and its
diameter cannot be less than 1.680 inches (which is a weight of 45.93 grams
and a diameter of 42.67 millimeters, in case you were wondering). The balls
are also tested by being hit at different speeds. For example, the distance
test involves having a mechanical golfer hit the ball with a titanium driver
and a swing speed of 120 miles per hour. As the testing center explains:
“The USGA system then uses an array of sensors that accurately measure
the flight of a golf ball during a short, indoor trajectory from a ball
launcher. From this flight data, a computer calculates the lift and drag
forces that are generated by the speed, spin, and dimple pattern of the ball.
… The distance limit is 317 yards.”
Over 1800 golf balls made by more than 100 companies meet the USGA
standards. The balls do differ in various ways, like the pattern of dimples on
the ball, the types of plastic used on the cover and in the cores, and so on.
Since all balls need to conform to the USGA tests, they are much more alike
than different. In other words, golf ball manufacturers are monopolistically
competitive.
However, retail sales of golf balls are about $500 million per year, which
means that a lot of large companies have a powerful incentive to persuade
players that golf balls are highly differentiated and that it makes a huge
difference which one you choose. Sure, Tiger Woods can tell the difference.
For the average duffer (golf-speak for a “mediocre player”) who plays a few
times a summer—and who loses a lot of golf balls to the woods and lake and
needs to buy new ones—most golf balls are pretty much indistinguishable.

How a Monopolistic Competitor Chooses Price and Quantity

The monopolistically competitive firm decides on its profit-maximizing
quantity and price in much the same way as a monopolist. A monopolistic
competitor, like a monopolist, faces a downward-sloping demand curve,
and so it will choose some combination of price and quantity along its
perceived demand curve.
As an example of a profit-maximizing monopolistic competitor, consider
the Authentic Chinese Pizza store, which serves pizza with cheese, sweet
and sour sauce, and your choice of vegetables and meats. Although
Authentic Chinese Pizza must compete against other pizza businesses and
restaurants, it has a differentiated product. The firm’s perceived demand
curve is downward sloping, as shown in Figure 2 and the first two columns
of Table 1.

Figure 2. How a Monopolistic Competitor Chooses its Profit Maximizing Output and Price. To
maximize profits, the Authentic Chinese Pizza shop would choose a quantity where marginal
revenue equals marginal cost, or Q where MR = MC. Here it would choose a quantity of 40 and a
price of $16.

Total Marginal Total Marginal Average

Quantity Price Revenue Revenue Cost Cost Cost

10 $23 $230 – $340 – $34

20 $20 $400 $17 $400 $6 $20

30 $18 $540 $14 $480 $8 $16

40 $16 $640 $10 $580 $10 $14.50

50 $14 $700 $6 $700 $12 $14

60 $12 $720 $2 $840 $14 $14

70 $10 $700 –$2 $1,020 $18 $14.57

 Total Marginal Total Marginal Average
Quantity Price Revenue Revenue Cost Cost Cost

80 $8 $640 –$6 $1,280 $26 $16

Table 1. Revenue and Cost Schedule

The combinations of price and quantity at each point on the demand curve
can be multiplied to calculate the total revenue that the firm would receive,
which is shown in the third column of Table 1. The fourth column, marginal
revenue, is calculated as the change in total revenue divided by the change
in quantity. The final columns of Table 1 show total cost, marginal cost, and
average cost. As always, marginal cost is calculated by dividing the change
in total cost by the change in quantity, while average cost is calculated by
dividing total cost by quantity. The following Work It Out feature shows
how these firms calculate how much of its product to supply at what price.

How a Monopolistic Competitor Determines How Much to Produce and at

What Price
The process by which a monopolistic competitor chooses its profit-
maximizing quantity and price resembles closely how a monopoly makes
these decisions process. First, the firm selects the profit-maximizing
quantity to produce. Then the firm decides what price to charge for that
quantity.
Step 1. The monopolistic competitor determines its profit-maximizing level
of output. In this case, the Authentic Chinese Pizza company will determine
the profit-maximizing quantity to produce by considering its marginal
revenues and marginal costs. Two scenarios are possible:
 If the firm is producing at a quantity of output where marginal revenue
exceeds marginal cost, then the firm should keep expanding production,
because each marginal unit is adding to profit by bringing in more
revenue than its cost. In this way, the firm will produce up to the
quantity where MR = MC.
 If the firm is producing at a quantity where marginal costs exceed
marginal revenue, then each marginal unit is costing more than the
revenue it brings in, and the firm will increase its profits by reducing
the quantity of output until MR = MC.
In this example, MR and MC intersect at a quantity of 40, which is the
profit-maximizing level of output for the firm.
Step 2. The monopolistic competitor decides what price to charge. When
the firm has determined its profit-maximizing quantity of output, it can
then look to its perceived demand curve to find out what it can charge for
that quantity of output. On the graph, this process can be shown as a
vertical line reaching up through the profit-maximizing quantity until it hits
the firm’s perceived demand curve. For Authentic Chinese Pizza, it should
charge a price of $16 per pizza for a quantity of 40.
Once the firm has chosen price and quantity, it’s in a position to calculate
total revenue, total cost, and profit. At a quantity of 40, the price of $16 lies
above the average cost curve, so the firm is making economic profits.
From Table 1 we can see that, at an output of 40, the firm’s total revenue is
$640 and its total cost is $580, so profits are $60. In Figure 2, the firm’s
total revenues are the rectangle with the quantity of 40 on the horizontal
axis and the price of $16 on the vertical axis. The firm’s total costs are the
light shaded rectangle with the same quantity of 40 on the horizontal axis
but the average cost of $14.50 on the vertical axis. Profits are total revenues
minus total costs, which is the shaded area above the average cost curve.
Although the process by which a monopolistic competitor makes decisions
about quantity and price is similar to the way in which a monopolist makes
such decisions, two differences are worth remembering. First, although
both a monopolist and a monopolistic competitor face downward-sloping
demand curves, the monopolist’s perceived demand curve is the market
demand curve, while the perceived demand curve for a monopolistic
competitor is based on the extent of its product differentiation and how
many competitors it faces. Second, a monopolist is surrounded by barriers
to entry and need not fear entry, but a monopolistic competitor who earns
profits must expect the entry of firms with similar, but differentiated,
products.

Monopolistic Competitors and Entry

If one monopolistic competitor earns positive economic profits, other firms
will be tempted to enter the market. A gas station with a great location must
worry that other gas stations might open across the street or down the
road—and perhaps the new gas stations will sell coffee or have a carwash or
some other attraction to lure customers. A successful restaurant with a
unique barbecue sauce must be concerned that other restaurants will try to
copy the sauce or offer their own unique recipes. A laundry detergent with a
great reputation for quality must be concerned that other competitors may
seek to build their own reputations.
The entry of other firms into the same general market (like gas, restaurants,
or detergent) shifts the demand curve faced by a monopolistically
competitive firm. As more firms enter the market, the quantity demanded
at a given price for any particular firm will decline, and the firm’s perceived
demand curve will shift to the left. As a firm’s perceived demand curve
shifts to the left, its marginal revenue curve will shift to the left, too. The
shift in marginal revenue will change the profit-maximizing quantity that
the firm chooses to produce, since marginal revenue will then equal
marginal cost at a lower quantity.
Figure 3 (a) shows a situation in which a monopolistic competitor was
earning a profit with its original perceived demand curve (D ). The 0

intersection of the marginal revenue curve (MR ) and marginal cost curve
0

(MC) occurs at point S, corresponding to quantity Q , which is associated on

0

the demand curve at point T with price P . The combination of price P and
0 0

quantity Q lies above the average cost curve, which shows that the firm is
0

earning positive economic profits.

Figure 3. Monopolistic Competition, Entry, and Exit. (a) At P0 and Q0, the monopolistically
competitive firm shown in this figure is making a positive economic profit. This is clear because
if you follow the dotted line above Q0, you can see that price is above average cost. Positive
economic profits attract competing firms to the industry, driving the original firm’s demand
down to D1. At the new equilibrium quantity (P1, Q1), the original firm is earning zero economic
profits, and entry into the industry ceases. In (b) the opposite occurs. At P0 and Q0, the firm is
losing money. If you follow the dotted line above Q0, you can see that average cost is above price.
Losses induce firms to leave the industry. When they do, demand for the original firm rises to
D1, where once again the firm is earning zero economic profit.
Unlike a monopoly, with its high barriers to entry, a monopolistically
competitive firm with positive economic profits will attract competition.
When another competitor enters the market, the original firm’s perceived
demand curve shifts to the left, from D to D , and the associated marginal
0 1

revenue curve shifts from MR to MR . The new profit-maximizing output is

0 1

Q , because the intersection of the MR and MC now occurs at point U.

1 1

Moving vertically up from that quantity on the new demand curve, the
optimal price is at P . 1

As long as the firm is earning positive economic profits, new competitors

will continue to enter the market, reducing the original firm’s demand and
marginal revenue curves. The long-run equilibrium is shown in the figure
at point Y, where the firm’s perceived demand curve touches the average
cost curve. When price is equal to average cost, economic profits are zero.
Thus, although a monopolistically competitive firm may earn positive
economic profits in the short term, the process of new entry will drive down
economic profits to zero in the long run. Remember that zero economic
profit is not equivalent to zero accounting profit. A zero economic profit
means the firm’s accounting profit is equal to what its resources could earn
in their next best use. Figure 3 (b) shows the reverse situation, where a
monopolistically competitive firm is originally losing money. The
adjustment to long-run equilibrium is analogous to the previous example.
The economic losses lead to firms exiting, which will result in increased
demand for this particular firm, and consequently lower losses. Firms exit
up to the point where there are no more losses in this market, for example
when the demand curve touches the average cost curve, as in point Z.
Monopolistic competitors can make an economic profit or loss in the short
run, but in the long run, entry and exit will drive these firms toward a zero
economic profit outcome. However, the zero economic profit outcome in
monopolistic competition looks different from the zero economic profit
outcome in perfect competition in several ways relating both to efficiency
and to variety in the market.

Monopolistic Competition and Efficiency

The long-term result of entry and exit in a perfectly competitive market is
that all firms end up selling at the price level determined by the lowest
point on the average cost curve. This outcome is why perfect competition
displays productive efficiency: goods are being produced at the lowest
possible average cost. However, in monopolistic competition, the end result
of entry and exit is that firms end up with a price that lies on the
downward-sloping portion of the average cost curve, not at the very bottom
of the AC curve. Thus, monopolistic competition will not be productively
efficient.
In a perfectly competitive market, each firm produces at a quantity where
price is set equal to marginal cost, both in the short run and in the long run.
This outcome is why perfect competition displays allocative efficiency: the
social benefits of additional production, as measured by the marginal
benefit, which is the same as the price, equal the marginal costs to society of
that production. In a monopolistically competitive market, the rule for
maximizing profit is to set MR = MC—and price is higher than marginal
revenue, not equal to it because the demand curve is downward sloping.
When P > MC, which is the outcome in a monopolistically competitive
market, the benefits to society of providing additional quantity, as
measured by the price that people are willing to pay, exceed the marginal
costs to society of producing those units. A monopolistically competitive
firm does not produce more, which means that society loses the net benefit
of those extra units. This is the same argument we made about monopoly,
but in this case to a lesser degree. Thus, a monopolistically competitive
industry will produce a lower quantity of a good and charge a higher price
for it than would a perfectly competitive industry. See the following Clear It
Up feature for more detail on the impact of demand shifts.

Why does a shift in perceived demand cause a shift in marginal revenue?

The combinations of price and quantity at each point on a firm’s perceived
demand curve are used to calculate total revenue for each combination of
price and quantity. This information on total revenue is then used to
calculate marginal revenue, which is the change in total revenue divided by
the change in quantity. A change in perceived demand will change total
revenue at every quantity of output and in turn, the change in total revenue
will shift marginal revenue at each quantity of output. Thus, when entry
occurs in a monopolistically competitive industry, the perceived demand
curve for each firm will shift to the left, because a smaller quantity will be
demanded at any given price. Another way of interpreting this shift in
demand is to notice that, for each quantity sold, a lower price will be
charged. Consequently, the marginal revenue will be lower for each
quantity sold—and the marginal revenue curve will shift to the left as well.
Conversely, exit causes the perceived demand curve for a monopolistically
competitive firm to shift to the right and the corresponding marginal
revenue curve to shift right, too.
A monopolistically competitive industry does not display productive and
allocative efficiency in either the short run, when firms are making
economic profits and losses, nor in the long run, when firms are earning
zero profits.

The Benefits of Variety and Product Differentiation

Even though monopolistic competition does not provide productive
efficiency or allocative efficiency, it does have benefits of its own. Product
differentiation is based on variety and innovation. Many people would
prefer to live in an economy with many kinds of clothes, foods, and car
styles; not in a world of perfect competition where everyone will always
wear blue jeans and white shirts, eat only spaghetti with plain red sauce,
and drive an identical model of car. Many people would prefer to live in an
economy where firms are struggling to figure out ways of attracting
customers by methods like friendlier service, free delivery, guarantees of
quality, variations on existing products, and a better shopping experience.
Economists have struggled, with only partial success, to address the
question of whether a market-oriented economy produces the optimal
amount of variety. Critics of market-oriented economies argue that society
does not really need dozens of different athletic shoes or breakfast cereals
or automobiles. They argue that much of the cost of creating such a high
degree of product differentiation, and then of advertising and marketing
this differentiation, is socially wasteful—that is, most people would be just
as happy with a smaller range of differentiated products produced and
sold at a lower price. Defenders of a market-oriented economy respond that
if people do not want to buy differentiated products or highly advertised
brand names, no one is forcing them to do so. Moreover, they argue that
consumers benefit substantially when firms seek short-term profits by
providing differentiated products. This controversy may never be fully
resolved, in part because deciding on the optimal amount of variety is very
difficult, and in part because the two sides often place different values on
what variety means for consumers. Read the following Clear It Up feature
for a discussion on the role that advertising plays in monopolistic
competition.

How does advertising impact monopolistic competition?

The U.S. economy spent about $180.12 billion on advertising in 2014,
according to eMarketer.com. Roughly one third of this was television
advertising, and another third was divided roughly equally between
Internet, newspapers, and radio. The remaining third was divided up
between direct mail, magazines, telephone directory yellow pages, and
billboards. Mobile devices are increasing the opportunities for advertisers.
Advertising is all about explaining to people, or making people believe, that
the products of one firm are differentiated from the products of another
firm. In the framework of monopolistic competition, there are two ways to
conceive of how advertising works: either advertising causes a firm’s
perceived demand curve to become more inelastic (that is, it causes the
perceived demand curve to become steeper); or advertising causes demand
for the firm’s product to increase (that is, it causes the firm’s perceived
demand curve to shift to the right). In either case, a successful advertising
campaign may allow a firm to sell either a greater quantity or to charge a
higher price, or both, and thus increase its profits.
However, economists and business owners have also long suspected that
much of the advertising may only offset other advertising. Economist A. C.
Pigou wrote the following back in 1920 in his book, The Economics of
Welfare:
It may happen that expenditures on advertisement made by competing monopolists
[that is, what we now call monopolistic competitors] will simply neutralise one
another, and leave the industrial position exactly as it would have been if neither had
expended anything. For, clearly, if each of two rivals makes equal efforts to attract the
favour of the public away from the other, the total result is the same as it would have
been if neither had made any effort at all.

Key Concepts and Summary

Monopolistic competition refers to a market where many firms sell
differentiated products. Differentiated products can arise from
characteristics of the good or service, location from which the product is
sold, intangible aspects of the product, and perceptions of the product.
The perceived demand curve for a monopolistically competitive firm is
downward-sloping, which shows that it is a price maker and chooses a
combination of price and quantity. However, the perceived demand curve
for a monopolistic competitor is more elastic than the perceived demand
curve for a monopolist, because the monopolistic competitor has direct
competition, unlike the pure monopolist. A profit-maximizing monopolistic
competitor will seek out the quantity where marginal revenue is equal to
marginal cost. The monopolistic competitor will produce that level of
output and charge the price that is indicated by the firm’s demand curve.
If the firms in a monopolistically competitive industry are earning
economic profits, the industry will attract entry until profits are driven
down to zero in the long run. If the firms in a monopolistically competitive
industry are suffering economic losses, then the industry will experience
exit of firms until economic profits are driven up to zero in the long run.
A monopolistically competitive firm is not productively efficient because it
does not produce at the minimum of its average cost curve. A
monopolistically competitive firm is not allocatively efficient because it
does not produce where P = MC, but instead produces where P > MC. Thus,
a monopolistically competitive firm will tend to produce a lower quantity at
a higher cost and to charge a higher price than a perfectly competitive firm.
Monopolistically competitive industries do offer benefits to consumers in
the form of greater variety and incentives for improved products and
services. There is some controversy over whether a market-oriented
economy generates too much variety.

Self-Check Questions

1. Suppose that, due to a successful advertising campaign, a monopolistic

competitor experiences an increase in demand for its product. How will
that affect the price it charges and the quantity it supplies?
2. Continuing with the scenario outlined in question 1, in the long run, the
positive economic profits earned by the monopolistic competitor will
attract a response either from existing firms in the industry or firms
outside. As those firms capture the original firm’s profit, what will
happen to the original firm’s profit-maximizing price and output levels?
Review Questions
1. What is the relationship between product differentiation and
monopolistic competition?
2. How is the perceived demand curve for a monopolistically competitive
firm different from the perceived demand curve for a monopoly or a
perfectly competitive firm?
3. How does a monopolistic competitor choose its profit-maximizing
quantity of output and price?
4. How can a monopolistic competitor tell whether the price it is charging
will cause the firm to earn profits or experience losses?
5. If the firms in a monopolistically competitive market are earning
economic profits or losses in the short run, would you expect them to
continue doing so in the long run? Why?
6. Is a monopolistically competitive firm productively efficient? Is it
allocatively efficient? Why or why not?
Critical Thinking Questions

1. Aside from advertising, how can monopolistically competitive firms

increase demand for their products?
2. Make a case for why monopolistically competitive industries never
reach long-run equilibrium.
3. Would you rather have efficiency or variety? That is, one opportunity
cost of the variety of products we have is that each product costs more
per unit than if there were only one kind of product of a given type, like
shoes. Perhaps a better question is, “What is the right amount of
variety? Can there be too many varieties of shoes, for example?”
Problems

Andrea’s Day Spa began to offer a relaxing aromatherapy treatment. The

firm asks you how much to charge to maximize profits. The demand curve
for the treatments is given by the first two columns in Table 2; its total costs
are given in the third column. For each level of output, calculate total
revenue, marginal revenue, average cost, and marginal cost. What is the
profit-maximizing level of output for the treatments and how much will the
firm earn in profits?
Price Quantity TC

$25.00 0 $130

$24.00 10 $275

$23.00 20 $435

$22.50 30 $610

$22.00 40 $800

$21.60 50 $1,005

$21.20 60 $1,225

Table 2.

References
Kantar Media. “Our Insights: Infographic—U.S. Advertising Year End
Trends Report 2012.” Accessed October 17, 2013.
http://kantarmedia.us/insight-center/reports/infographic-us-advertising-
year-end-trends-report-2012.
Statistica.com. 2015. “Number of Restaurants in the United States from
2011 to 2014.” Accessed March 27, 2015.
http://www.statista.com/statistics/244616/number-of-qsr-fsr-chain-
independent-restaurants-in-the-us/.

Glossary
differentiated product
a product that is perceived by consumers as distinctive in some way
imperfectly competitive
firms and organizations that fall between the extremes of monopoly
and perfect competition
monopolistic competition
many firms competing to sell similar but differentiated products
oligopoly
when a few large firms have all or most of the sales in an industry
Solutions
Answers to Self-Check Questions
1. An increase in demand will manifest itself as a rightward shift in the
demand curve, and a rightward shift in marginal revenue. The shift in
marginal revenue will cause a movement up the marginal cost curve to
the new intersection between MR and MC at a higher level of output.
The new price can be read by drawing a line up from the new output
level to the new demand curve, and then over to the vertical axis. The
new price should be higher. The increase in quantity will cause a
movement along the average cost curve to a possibly higher level of
average cost. The price, though, will increase more, causing an increase
in total profits.
2. As long as the original firm is earning positive economic profits, other
firms will respond in ways that take away the original firm’s profits.
This will manifest itself as a decrease in demand for the original firm’s
product, a decrease in the firm’s profit-maximizing price and a decrease
in the firm’s profit-maximizing level of output, essentially unwinding
the process described in the answer to question 1. In the long-run
equilibrium, all firms in monopolistically competitive markets will earn
zero economic profits.