HCS 112 Fundamentals of Economics Monopolistic Lecture Notes
What is Monopolistic Competition?
Monopolistic competition is characterized by four factors: a large number of firms, product
differentiation, competition on price, product quality, and marketing, and firms are free to enter
and exit.
A. A Large Number of Firms
The large number of firms implies
1. A small market share for each firm.
2. No market dominance by a single firm, so no one’s firm’s actions directly affect the actions of
other firms.
3. Collusion is impossible because there are so many firms.
B. Product Differentiation
Product differentiation is making a product that is slightly different from the products of
competing firms. As a result there are no perfect substitutes and so the firm in monopolistic
competition faces a downward-sloping demand curve.
C. Competing on Quality, Price, and Marketing
A firm in monopolistic competition will compete on:
1. Quality
A firm promotes the idea that its product has better attributes than its competitors’ products.
These attributes include design, reliability, the service provided to the buyer, and the buyer’s
ease of access to the product.
2. Price
A firm in monopolistic competition faces a downward-sloping demand curve so the firm can set
both its price and its output.
3.Marketing
A firm uses advertising and packaging to publicize its product’s uniqueness.
D. Entry and Exit
If firms in monopolistic competition earn an economic profit in the short run, new firms enter
the market. This increase in supply decreases each firm’s demand and lowers the price until only
a normal profit is earned. If firms incur economic losses in the short run, some firms exit the
industry. The price rises until a normal profit is earned by the remaining firms.
E. Identifying Monopolistic Competition.
1. The Four-Firm Concentration Ratio
The four-firm concentration ratio is the percentage of the value of sales accounted for by the
four largest firms in an industry. A four-firm concentration ratio that exceeds 60 percent is
regarded as an indication of a market that is highly concentrated and dominated by a few firms
in an oligopoly. A ratio of less than 40 percent is regarded as an indication of a competitive
market—monopolistic competition.
2. Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is the square of the percentage market share of each
firm summed over the 50 largest firms (or summed over all the firms if there are fewer than 50)
in a market. If the HHI is greater than 1,800, the market is regarded as being uncompetitive. This
measure is used as a guideline by the Justice Department for decisions regarding whether to
challenge a merger.
3. Limitations of Concentration Ratios
a. Geographic Scope of the Market
Concentration ratios take a national view of the market but some goods are sold in regional
markets (in which case the extent of competition might be overstated) and others in global
markets (in which case the extent of competition might be understated).
b. Barriers to Entry and Firm Turnover
Concentration ratios don’t take account of the absence or presence of barriers to entry.
15.2 Output and Price Decisions
A. The Firm’s Profit-Maximizing Decision
1. Facing a downward-sloping demand curve, a firm in monopolistic competition chooses its
profit-maximizing price and quantity as does a monopoly.
2. The firm produces at the quantity that sets marginal revenue equal to marginal cost. The firm
charges the price that buyers are willing to pay for this quantity, which is determined by the
demand curve.
3. Economic profit in the short run is possible and equals quantity  (price  average total cost).
B. Profit Maximizing Might Be Loss Minimizing
If price is less than average total cost, a firm in monopolistic competition incurs an economic
loss.
C. Long Run: Zero Economic Profit
1. There is no restriction on entry in monopolistic competition, so if firms in monopolistic
competition are earning an economic profit, other firms to enter the industry. As new firms
enter, an individual firm’s demand and marginal revenue decrease. New firms enter until
economic profit disappears and the remaining firms earn normal profit.
2. If firms in monopolistic competition are incurring an economic loss, some firms leave the
industry. As firms exit, a remaining firm’s demand and marginal revenue increase. Firms exit
until economic loss disappears and the remaining firms earn normal profit.
D. Monopolistic Competition and Perfect Competition
1. Excess Capacity
Excess capacity occurs when the quantity that a firm produces is less than the quantity at which
average total cost is a minimum. A firm with excess capacity produces below its efficient scale,
which is the quantity at which average total cost is a minimum.
2. Markup
Markup is the amount by which price exceeds marginal cost. A firm in monopolistic competition
has a markup because price exceeds marginal cost but a firm in perfect competition has no
markup.
E. Monopolistic Competition and Efficiency
1. Making the Relevant Comparison
A firm in monopolistic competition chooses a profit-maximizing quantity where the markup is
positive (price is greater than marginal cost), which means that marginal benefit exceeds
marginal cost. This choice implies that the firm inefficiently uses resources. (Efficiency requires
that price = marginal benefit = marginal cost). But a benefit of monopolistic competition is that
it creates product variety.
2. The Bottom Line
Compared to the alternative—complete product uniformity—monopolistic competition is
efficient.
15.3 Product Development and Marketing
A. Innovation and Product Development
A firm in monopolistic competition will continuously develop new products so that it can
continue to earn an economic profit. If the firm does not innovate, new firms will enter the
market and capture the existing firm’s economic profit.
1. Cost Versus Benefit of Product Innovation
To decide the degree to which it will innovate, a firm compares the marginal cost of innovation
to the marginal benefit of innovation.
2. Efficiency and Product Innovation
On one hand, product innovation brings to market many improved products that have great
benefits to consumers. On the other hand, many so-called improvements amount to little more
than packaging changes.
B. Advertising
A firm uses advertising and packaging to convince consumers that its product differs from and is
better than other products. These differences can be real or perceived.
1. Advertising Expenditures
The cost of selling a good can represent a large portion of the price that consumers pay for a
product.
2. Selling Costs and Total Costs
Selling costs, such as advertising expenditures are fixed costs and increase total costs. These
expenditures shift the average total cost curve upward. If advertising expenditures increase
sales enough, the average total cost of the amount produced might decrease.
3. Selling Costs and Demand
Advertising might increase demand for a firm’s product (by taking away other firms’ customers)
or might decrease demand (as new firms enter the market trying to earn an economic profit).
C. Using Advertising to Signal Quality
A signal is an action taken by an informed person (or firm) to send a message to uninformed
people. A firm uses advertising to signal consumers that its product differs from and is better
than other products.
D. Brand Names
Brand names provide information to consumers about the quality of a product and provide an
incentive to producers to keep the quality high and consistent.
E. Efficiency of Advertising and Brand Names
Whether advertising and brand names lead to efficiency is ambiguous. We must compare the
benefits of the information provided by these means with the opportunity cost of the additional
information.