14 MONOPOLISTIC COMPETITION After studying this chapter you will be able to Define and identify monopolistic competition Explain how a firm in monopolistic competition determines its price and output in the short run and the long run Explain why advertising costs are high and why firms in a monopolistic competition use brand names 2014 Pearson Addison Wesley The online shoe store shoebuy com lists athletic shoes made by 56 different producers in 40 categories Athletic shoe producers compete but each has a monopoly on its own special kind of shoe With so many different types of athletic shoes the market isn t perfectly competitive The model of monopolistic competition helps us to understand the competition that we see every day in the markets for athletic shoes and most other goods and services we buy 2014 Pearson Addison Wesley What Is Monopolistic Competition Monopolistic competition is a market structure in which A large number of firms compete Each firm produces a differentiated product Firms compete on product quality price and marketing Firms are free to enter and exit the industry 2014 Pearson Addison Wesley 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 others So no one firm s actions directly affect the actions of others Collusion or conspiring to fix prices is impossible 2014 Pearson Addison Wesley What Is Monopolistic Competition Product Differentiation A firm in monopolistic competition practices product differentiation if the firm makes a product that is slightly different from the products of competing firms 2014 Pearson Addison Wesley Product differentiation the heart of the space between monopoly and competition Ice cream on the beach monopolistic competition fills the space between monopoly and perfect competition A B An ice cream vendor decides to set up shop on the beach the only one Where will she locate 2014 Pearson Addison Wesley What Is Monopolistic Competition 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 the demand for each firm s product is downward sloping But there is a tradeoff between price and quality Because products are differentiated a firm must market its product Marketing takes the two main forms advertising and packaging 2014 Pearson Addison Wesley Monopolistic Competition Entry and Exit There are no barriers to entry in monopolistic competition so firms cannot make an economic profit in the long run Examples of Monopolistic Competition Producers of audio and video equipment clothing jewelry computers and sporting goods operate in monopolistic competition 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition The Firm s Short Run Output and Price Decision A firm that has decided the quality of its product and its marketing program produces the profit maximizing quantity the quantity at which MR MC Price is determined from the demand for the firm s product and is the highest price that the firm can charge for the profit maximizing quantity Figure 14 1 shows a firm s economic profit in the short run 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition The firm in monopolistic competition operates like a single price monopoly The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price It makes an economic profit as in this example when P ATC 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition Profit Maximizing Might Be Loss Minimizing A firm might incur an economic loss in the short run Here is an example At the profit maximizing quantity P ATC and the firm incurs an economic loss 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition Long Run Zero Economic Profit In the long run economic profit induces entry And entry continues as long as firms in the industry earn an economic profit as 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 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition 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 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition Figure 14 3 shows a firm in monopolistic competition in long run equilibrium 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition 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 firm s markup is the amount by which its price exceeds its marginal cost 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition Firms in monopolistic competition operate with excess capacity in longrun equilibrium Firms produce less than the efficient scale the quantity at which ATC is a minimum The downward sloping demand curve for their products drives this result 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition Firms in monopolistic competition operate with positive markup Again the downwardsloping demand curve for their products drives this result 2014 Pearson Addison Wesley Price and Output in Monopolistic 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 2014 Pearson Addison Wesley Price and Output in Monopolistic Competition Is Monopolistic Competition Efficient Price equals marginal social benefit The firm s marginal cost equals marginal social cost Because price exceeds marginal cost marginal social benefit exceeds marginal social cost so in