Monopolistic Competition and Oligopoly ANSWERS TO END OF CHAPTER QUESTIONS 23 1 23 2 23 3 How does monopolistic competition differ from pure competition in its basic characteristics From pure monopoly Explain fully what product differentiation may involve Explain how the entry of firms into its industry affects the demand curve facing a monopolistic competitor and how that in turn affects its economic profit In monopolistic competition there are many firms but not the very large numbers of pure competition The products are differentiated not standardized There is some control over price in a narrow range whereas the purely competitive firm has none There is relatively easy entry in pure competition entry is completely without barriers In monopolistic competition there is much nonprice competition such as advertising trademarks and brand names In pure competition there is no nonprice competition In pure monopoly there is only one firm Its product is unique and there are no close substitutes The firm has much control over price being a price maker Entry to its industry is blocked Its advertising is mostly for public relations Product differentiation may well only be in the eye of the beholder but that is all the monopolistic competitor needs to gain an advantage in the market provided of course the consumer looks upon the assumed difference favorably The real differences can be in quality in services in location or even in promotion and packaging which brings us back to where we started possibly nonexistent differences To the extent that product differentiation exists in fact or in the mind of the consumer monopolistic competitors have some limited control over price for they have built up some loyalty to their brand When economic profits are present additional rivals will be attracted to the industry because entry is relative easy As new firms enter the demand curve faced by the typical firm will shift to the left fall Because of this each firm has a smaller share of total demand and now faces a larger number of close substitute products This decline firm s demand reduces its economic profit Key Question Compare the elasticity of the monopolistically competitor s demand curve with that of a pure competitor and a pure monopolist Assuming identical long run costs compare graphically the prices and output that would result in the long run under pure competition and under monopolistic competition Contrast the two market structures in terms of productive and allocative efficiency Explain Monopolistically competitive industries are characterized by too many firms each of which produces too little The monopolistic competitor s demand curve is less elastic than a pure competitor and more elastic than a pure monopolist Your graphs should look like Figures 21 12 and 23 1 in the chapters Price is higher and output lower for the monopolistic competitor Pure competition P MC allocative efficiency P minimum ATC productive efficiency Monopolistic competition P MC allocative efficiency and P minimum ATC productive inefficiency Monopolistic competitors have excess capacity meaning that fewer firms operating at capacity where P minimum ATC could supply the industry output Monopolistic competition is monopoly up to the point at which consumers become willing to buy close substitute products and competitive beyond that point Explain As long as consumers prefer one product over another regardless of relative prices the seller of the product is a monopolist But in monopolistic competition this happy state is limited because there are many other firms producing similar products When one firm s prices get too high as viewed by consumers people will switch brands At this point our firm has entered the competitive zone unwillingly which is why monopolistically competitive firms are forever trying to find ways to differentiate their products more thoroughly and thus to gain more monopoly price setting power 349 Monopolistic Competition and Oligopoly 23 4 23 5 23 6 Competition in quality and in service may be just as effective as price competition in giving buyers more for their money Do you agree Why Explain why monopolistically competitive firms frequently prefer nonprice to price competition This can certainly be true It depends on how much consumers value quality and service and are willing to pay for it through higher product prices In a monopolistically competitive market the consumer can buy a substitute brand for a lower price if the consumer prefers a lower price to better quality and service The monopolistically competitive firm frequently prefers nonprice competition to price competition because the latter can lead to the firm producing where P ATC and thus making no economic profit or worse producing in the short run where P ATC and thus losing money with the possibility of eventually going out of business Nonprice competition on the other hand if successful results in more monopoly power The firm s product has become more differentiated from now less similar competitors in the industry This increase in monopoly power allows the firm to raise its price with less fear of losing customers Of course the firm must still follow the MR MC rule but its success in nonprice competition has shifted both the demand and MR curves upward to the right This results in simultaneously a larger output a higher price and more economic profits Critically evaluate and explain a In monopolistically competitive industries economic profits are competed away in the long run hence there is no valid reason to criticize the performance and efficiency of such industries b In the long run monopolistic competition leads to a monopolistic price but not to monopolistic profits a The first part of the statement may well be true but it does not lead logically to the second part The criticism of monopolistic competition is not related to the profit level but to the fact that the firms do not produce at the point of minimum ATC and do not equate price and MC This is the inevitable consequence of imperfect competition and its downward sloping demand curves With P minimum ATC productive efficiency is not attained The firm is producing too little at too high a cost it is wasting some of its productive capacity With P MC the firm is not allocating resources in accordance with society s desires the value society sets on the product P is greater than the cost of producing the last item MC b The statement is often true since competition