Ch 16: Monopolistic CompetitionMonday, November 17, 20141:22 AM -On one hand, the market for books seems competitive. A buyer in this market has thousands of competing products from which to choose. And because anyone can enter the industry by writing and publishing a book, the book business is not very profitable. For every highly paid novelist, there are hundreds of struggling ones-On the other hand, the market for books seems monopolistic. Because each book is unique, publishers have some latitude in choosing what price to charge. The sellers in this market are price makers rather than price takers. -The market for books fits neither the competitive nor the monopoly model. Instead, it is best described by the model of monopolistic competition. Between Monopoly and Perfect Competition-In a perfectly competitive market…oPrice always equals the marginal cost of productionoIn the long run, entry and exit drive economic profit to zero, so the price also equals the average total cost-In a monopoly…oFirms can use their market power to keep prices above marginal cost, leading to a positive economic profit for the firm and a deadweight loss for society.-Many industries fall somewhere between the polar cases of perfect competition and monopoly. Economists call this imperfect competition. -Oligopoly: a market structure in which only a few sellers offer similar or identical productsoEconomists measure a market's domination by a small number of firms with a statistic called concentration ratio, which is the percentage of total output in the market supplied by the four largest firms. -Monopolistic competition: a market structure in which many firms sell products that are similar but not identicaloMany sellers: there are many firms competing for the same group of customersoProduct differentiation: Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward sloping demand curve. oFree entry and exit: firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero Number of Firms?Many firmsTypes of Products? One firm Few firmsIdentical products Differentiated productsMonopoly-tap water-cable TV Oligopoly-tennis balls-cigarettesMonopolisticCompetition-novels-moviesPerfectCompetition-wheat-milkCompetition with Differentiated Products-The Monopolistically Competitive Firm in the Short RunoEach firm in a monopolistically competitive market is like a monopolyoMonopolistic competitors, like monopolists, maximize profit by producing the quantity at which MR equals MC.-A firm makes a profit at this quantity if price is above average total cost at this point-A firm makes losses at this quantity if price is less than average total cost at this pointoIn the short run, a monopolistically competitive firm and a monopoly have a similar market structure-The Long Run EquilibriumoThe short run situations do not last long because profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms' product falls, these firms experience declining profit. oLosses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms' product rises, these firms experience rising profit (that is, declining losses)oEntry and exit continues until the firms are making exactly zero economic profit where price equals average total cost. Price -Monopolistic versus Perfect CompetitionoTwo important differences: excess capacity and the markupoExcess Capacity-The quantity that minimizes ATC is called the efficient scale of the firm. In the long run, perfectly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. -Firms are said to have excess capacity under monopolistic competition. A monopolistically competitive firm, unlike a perfectly competitive firm, could increase the quantity it produces and lower the ATC of production. It is more profitable for a monopolistic competitor to continue operating with excess capacityoMarkup over Marginal Cost-In a perfectly competitive firm, the price equals MC so the profit from an extra unit sold is zero. In a monopolistically competitive firm, price exceeds MC so an extra unit sold at the posted price means more profit.MCoTwo characteristics describe the long run equilibrium in a monopolistically competitive market:1. As in a monopoly market, price exceeds marginal cost. This conclusion arises because profit maximization requires MR to equal MC and because the downward sloping demand curve makes MR less than the price. 2. As in a competitive market, price equals ATC. This conclusion arises because free entry and exit drive economic profit to zero. ATCP=ATC_ _ _ Demand MRQuantityProfit-maximizingquantity Monopolistically Competitive FirmPerfectly Competitive Firm Price MC MCATC ATC Markup P• .. . , .•P=MC{P = MR(demandCurve)MarginalCost D_ _|MRQuantity produced =efficient scale Quantity Efficient Produced ScaleExcess capacity 1. The perfectly competitive firm produces at the efficient scale, where ATC is minimized. By contrast, the monopolistically competitive firm produces less than the efficient scale. 2. Price equals MC under perfect competition, but price is above MC under monopolistic competition-Monopolistic Competition and the Welfare of SocietyoOne source of inefficiency is the markup price over MC. Some consumers who value the good at more than the MC of production (but less than the price) will be deterred from buying it. So a monopolistically competitive market as the normal deadweight loss of monopoly pricing. oAnother way in which monopolistic competition may be socially inefficient is that the number of firms may not be ideal. There may be too much or too little entry. Whenever a new firm considers entering the market with a new product it takes into account only the profit it would make. Its entry would also have two effects that are external to the firm:1. The product-variety externality: because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers-Arises because a new firm would offer a product different from