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Monopolistic Competition
• Characteristics:
–
–
–
–
Many sellers
Product differentiation
Free entry and exit
In the long run, profits are
driven to zero
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Monopolistic Competition
• Free Entry or Exit
• Firms can enter or exit the market without
restriction.
• The number of firms in the market adjusts until
economic profits are zero.
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What does the costs graph for one of
these firms look like?
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The Monopolistically Competitive Firm in
the Short Run
• Two things can happen
• A firm could experience economic loss
• A firm could experience economic profit
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What if a firm is earning profit?
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Figure 1 Monopolistic Competition in the Short Run
(a) Firm Makes Profit
Price
MC
ATC
Price
Average
total cost
Demand
Profit
MR
0
Profitmaximizing
quantity
Quantity
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Short Run Profits
• Encourage new firms to enter the market.
This:
– Increases the number of products offered.
– Reduces demand faced by firms already in
the market.
• Demand curves shift to the left.
• Profits decline.
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In the long run, firms will continue to
enter the market until a firm’s
economic profit is driven to zero…
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Figure 2 A Monopolistic Competitor in the Long Run
Price
MC
ATC
When profit is earned,
firms will enter the
market until profit is
driven to zero
P = ATC
Demand
MR
0
Profit-maximizing
quantity
And this tangency lies
vertically above the
intersection of MR and
MC.
Quantity
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The Long-Run Equilibrium
• Two Characteristics
• As in a monopoly, price exceeds marginal cost.
• Profit maximization requires marginal revenue to equal
marginal cost.
• The downward-sloping demand curve makes marginal
revenue less than price.
• As in a competitive market, price equals average
total cost.
• Free entry and exit drive economic profit to zero.
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What if a firm has short run losses?
• Firms will exit the market
• Decreases the number of products offered.
• Increases demand faced by the remaining firms.
• Shifts the remaining firms’ demand curves to the
right.
• Increases the remaining firms’ profits.
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Figure 1 Monopolistic Competitors in the Short Run
(b) Firm Makes Losses
Price
MC
ATC
Losses
Average
total cost
Price
MR
0
Lossminimizing
quantity
Demand
Quantity
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Problem Set 5.7
• Find a partner, put your desks together, and
dominate the worksheet!
• Raise your hand for any questions
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Monopolistic versus Perfect Competition
• There is a noteworthy difference between
monopolistic and perfect competition:
• Excess capacity
• The actual capacity (production) by a firm is less than
what is optimum for the firm
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Monopolistic versus Perfect Competition
• Excess Capacity
• There is no excess capacity in perfect competition
in the long run.
• There is excess capacity in monopolistic
competition in the long run.
• In monopolistic competition, output is less than the
efficient scale.
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Figure 3 Monopolistic versus Perfect Competition
(a) Monopolistically Competitive Firm
Price
(b) Perfectly Competitive Firm
Price
MC
MC
ATC
ATC
P
P = MC
MR
0
Quantity
produced
Efficient
scale
P = MR
(demand
curve)
Demand
Quantity
0
Quantity produced =
Efficient scale
Quantity
Excess capacity
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Monopolistic Competition
and the Welfare of Society
• There is the normal deadweight loss of
monopoly pricing in monopolistic competition
caused by the markup of price over marginal
cost.
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Deadweight Loss
Price
MC
ATC
P = ATC
Demand
MR
0
Monopoly
quantity
Market
efficient
quantity
Quantity
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ADVERTISING
• When firms sell differentiated products and
charge prices above marginal cost, each firm
has an incentive to advertise in order to attract
more buyers to its particular product.
• The firm is trying to shift their demand curve
to the right to make more short-run profits.
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