Monopolistic Competition

Copyright 2004 South-Western

Tap water
Cable TV
Monopoly
Novels
Movies
Monopolistic
Competition
Tennis balls
Crude oil
Oligopoly
Number of Firms
Perfect
Wheat
Milk
Competition
Type of Products
Identical
products
Differentiated
products
One
firm
Few
firms
Many
firms
Monopolistic Competition
Two key characteristics:
Firms compete by selling differentiated products
that are highly substitutable for one another but
not perfect substitutes. In other words, the cross-
price elasticities of demand are large but not infinite.
There is free entry and exit: it is relatively easy for
new firms to enter the market with their own brands
and for existing firms to leave if their products
become unprofitable.


Because the firm is the only producer of its brand,
it faces a downward-sloping demand curve.
Price exceeds marginal cost and the firm has
monopoly power

Market Entry and
Monopolistic Competition
Firms enter an oligopolistic market in response to
profit opportunities
Several factors affect the number of firms that enter:
Fixed cost associated with becoming active in the market
As the fixed cost shrinks and the number of firms grows, the
possible profits of an active firm approach zero
Size of the market
Intensity of competition
Because profits are lower in a market with more intense
competition, fewer firms will enter
19-3
Figure 19.17: Factors Affecting the Number
of Firms
19-4
Product Differentiation and Monopolistic
Competition
In markets with product differentiation firms must decide
what kind of good to produce
Monopolistic competition is a market with:
A large number of firms
Each produces a unique product
Prices above marginal cost
Close to zero profit, net of fixed costs
Firms demand curve is downward sloping due to
differentiation
At the firms profit-maximizing price and quantity, P=AC so
the firm breaks even
Entry in monopolistically competitive markets may be
excessive or insufficient relative to the level that maximizes
aggregate surplus
19-5
Monopolistic Competition
19-6
Equilibrium in the Short Run and the Long
Run

Short run: price
exceeds average
cost, and the firm
earns profits
shown by the
yellow-shaded
rectangle

Long run: these
profits attract new
firms with
competing brands.
The firms market
share falls,
demand curve
shifts till P= AC

Short run Long run
In evaluating monopolistic competition, these
inefficiencies must be balanced against the gains to
consumers from product diversity.
Under
monopolistic
competition,
P>MC.
deadweight loss:
yellow-shaded
area.
The demand
curve is
downward-
sloping, so the
zero-profit point
is to the left of
the point of
minimum AC.

In both PC and Monopolistically Competitive markets, entry occurs until
profits are driven to zero.
Under PC, P=MC. The demand curve facing the firm is horizontal, so the
zero-profit point occurs at the point of minimum AC


Welfare Effects
Perfect competition Monopolistic competition