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Chapter 16: Monopolistic Competition

Monopolistic Competition
– Many sellers
– Each firms product is at least slightly different from another firm’s
– Free entry and exit ( no barriers to entry)
– Firms are price setters to some degree
such as:

1. restaurants
2. Most retailers

Maximizing profit
Maximizing profit
– The monopolistically competitive firm produces where its MC =MR and chargers a price based on demand
– In the short run, a monopolistically competitive firm behaves just like a monopolist
Monopolistic competition in the Short Run
Monopolistic competition in the Short Run
– Short Run economic profits encourage new firms to enter the market

– This:
1. Increases the number of products offered
2.Reduces demand faced by firms already in the market
3. Existing firm’s demand curves shift to the left
4. Existing firm’s profits decline

-Short Run economic losses encourage firms to exit the market

– This:
1. Decreases the number of products offered
2. Increases demand faced by the remaining firms
3. Shifts the remaining firms demand curves to the right
4. Increase the remaining firm’s profits

– Firms will enter and exit until the firms are making exactly zero economic profits, just like perfect competition
– Firms make zero economic profits when P=ATC

Two Characteristics of Monopolistic Competition
1. As in a monopoly, price exceeds marginal cost

2. As in a competitive market, price equals average total cost in Long run equilibrium

– One big difference between perfect competition and monopolistic competition is the Q produced in the Long Run
– Monopolistically competitive firms produce at a level we call excess capacity

Monopolistic Versus Perfect Competition in Long Run Equilibrium
– For a competitive firm, p=MC
– For a monopolistically competitive firm, p>MC
– Because P>MC, an extra unit sold at the going price means more profit for the monopolistically competitive firm
– A firm wants more customers, so it will advertise to get them!
Critics of advertising argue:

– Firms advertise in order to manipulate people’s tastes
– Advertising impedes competition

Defenders argue:

-Advertising provides information to consumers
– Consumers can “shop around” for deals more easily
– Advertising increases competition by offering a greater variety of products and prices

– The willingness of a firm to spend advertising dollars can be signal to consumers about the quality of product
– Ads may convince buyers to try a product once, but product must be of high quality for people to become repeat buyers
-Most expensive ads are not worthwhile unless they lead to repeat buyers

Deadweight Loss in a monopoly
Deadweight Loss in a monopoly
– Just like monopoly, there are deadweight losses due to monopolistic competition that make it socially inefficient
– Another way in which monopolistic competition may be socially inefficient is:
1. The number of firms in the market may not be the “ideal”one;and
2. There may be too much or too little entry
3. There may be externalities

A product-variety externality:
– Entry of a new firm can be a positive eternality on consumers
– If product-variety externality greater than the business-stealing externality, more firms are desirable

A business-stealing externality:
– Entry of new firm imposes negative externality on existing firms
– If business-stealing externality greater than the product-variety externality, fewer firms are desirable


-In the Short Run, firms resemble monopolies

– in the Long run, firms resemble perfect competition

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