Module
34
Monopolistic Competition
Module Objectives
Students will learn in this module:
• How prices and profits are determined in monopolistic competition, both in the
short run and in the long run.
• How monopolistic competition can lead to excess capacity and inefficiency.
Module Outline
I.Understanding Monopolistic Competition
A.Monopolistic competition in the short run
1. Because there are many firms in monopolistic competition, firms cannot
collude to increase their market power.
2. Each firm in a monopolistically competitive industry faces a downwardsloping demand curve and a downward-sloping marginal revenue curve.
3. In the short run, a monopolistically competitive firm has an upwardsloping marginal cost curve and a U-shaped average total cost curve.
4. To maximize profits in the short run, a monopolistically competitive firm
should choose an output level were marginal revenue is equal to marginal
cost.
5. The key to whether a firm with market power is profitable or unprofitable
in the short run lies in the relationship between its demand curve and its
average total cost curve.
6. If the average total cost curve is below the demand curve at the profitmaximizing level of output, then the monopolistically competitive firm is
profitable.
7. If the average total cost curve is above the demand curve at the profitmaximizing level of output, then the monopolistically competitive firm is
unprofitable.
8. Text Figure 34-1, shown on the next page, illustrates monopolistic competition in the short run.
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The Monopolistically Competitive Firm in the Short Run
(b) An Unprofitable Firm
(a) A Profitable Firm
Price,
costs,
marginal
revenue
Price,
costs,
marginal
revenue
MC
MC
ATC
ATC
PP
ATCU
PU
Profit
ATCP
Loss
DP
DU
MRP
MRU
QU
Quantity
QP
Profit-maximizing quantity
Quantity
Loss-minimizing quantity
B. Monopolistic competition in the long run
1. Entry and exit affect the demand curve of every firm in the market.
2. If firms are earning economic profits, new firms will enter the market,
shifting the demand curve for the existing firms to the left.
3. If firms are incurring losses, firms exit the industry, shifting the demand
curve for existing firms to the right.
4. The market is in long-run equilibrium when there is no exit or entry.
5. Definition: In the long run, a monopolistically competitive industry ends
up in zero-profit equilibrium: Each firm makes zero profit at its profitmaximizing quantity (see text Figure 34-3, shown below).
6. In the long run, firms will earn zero economic profits, and each firm’s
average total cost curve will be tangent to its demand curve at the profitmaximizing level of output.
The Long-Run Zero-Profit Equilibrium
Price,
costs,
marginal
revenue
MC
Point of tangency
ATC
PMC = ATCMC
Z
MRMC
QMC
DMC
Quantity
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II.Monopolistic Competition Versus Perfect Competition
A.Price, marginal cost, and average total cost
1. Monopolistically competitive firms and perfectly competitive firms are
similar in that in the long run both receive a price that is equal to their
average total cost. This is illustrated in text Figure 34-4, shown below.
Comparing Long-Run Equilibrium in Perfect Competition and Monopolistic Competition
(a) Long-Run Equilibrium in
Perfect Competition
Price,
costs,
marginal
revenue
MC
(b) Long-Run Equilibrium
in Monopolistic Competition
ATC
Price,
costs,
marginal
revenue
MC
ATC
PMC = ATCMC
PPC = MCPC =
D = MR = PPC
ATCPC
MCMC
QPC
Minimum-cost output
Quantity
MRMC
DMC
QMC
Quantity
Minimum-cost output
2. They differ in the following ways:
a.The price a perfectly competitive firm earns is equal to its marginal
cost. A monopolistically competitive firm earns a price that is above
its marginal cost. For this reason, monopolistically competitive firms
want to sell more than they are currently selling at the going price.
b.Firms in perfect competition earn a price that is equal to their minimum average total cost, while monopolistically competitive firms produce less than the quantity that would minimize average total cost.
c.Definition: Firms in monopolistic competition face excess capacity:
They produce at an output that is less than what would minimize
average total cost.
B.Is monopolistic competition inefficient?
1. Some mutually beneficial trades go unrealized.
2. The excess capacity leads to wasteful duplication: There are too many
varieties of products.
3. Consumers, however, do benefit from the diversity of products in monopolistic competition.
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Teaching Tips
Understanding Monopolistic Competition
Creating Student Interest
Have students create a list of firms in the area that have recently entered or exited.
Discuss what type of products the firms sell. How many other firms sell the same
product?
Presenting the Material
Explain that firms in monopolistic competition have some market power because they
can differentiate their product, and they also face a downward-sloping demand curve. Give a concrete example of a monopolistically competitive firm in the short run and have
students determine the output level and price at which profits will be maximized. Use
the table shown below.
Quantity Price
0
$17
Total
revenue
$0
1
16
15
3
14
4
13
5
12
6
11
7
10
8
9
9
8
25
27
28
32
38
48
72
62
8
–2
5
+7
2
8.3
+17
2
6.8
+25
3
5.6
+32
4
5.3
+34
6
5.4
+32
10
6
0
Profit
— –$10
11.5
2
72
4
70
23
Marginal
cost
18
6
66
18
8
60
—
10
52
Average total cost
12
42
$10
14
30
Total cost
16
16
2
Marginal revenue
+24
14
6.9
+10
The profit-maximizing price is $11, and the output is 6. Total profits at this level of production are $34. Point out that the first two columns represent the demand curve; the
fourth column is the downward-sloping marginal revenue curve. Draw a graph to illustrate the profit-maximizing output and the level of profit. Point out
to the students that in the short run this looks just like the monopoly outcome. In the
long run, the monopolistically competitive firm will earn zero economic profit just like
the perfectly competitive firm. Be sure to discuss what happens to the firm’s demand
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monopolistic competition
and marginal revenue curves when firms enter this industry (where firms are earning
positive profit). Illustrate the long-run equilibrium and make sure students understand
why economic profit will be equal to zero.
Monopolistic Competition Versus Perfect Competition
Creating Student Interest
Ask students to name a “monopolistic” industry. See how long it takes for someone in
the class to ask whether you mean a monopoly or a monopolistically competitive industry. Use the confusion to point out the difference between the two market structures and
the importance of being clear about which one you are talking about (by not simply saying “monopolistic”). Ask what makes a monopolistically competitive firm competitive
and what makes it like a “mini-monopoly.”
Presenting the Material
Use the characteristic of market structures (number of firms, type of product, control
over price, ease of entry) to show that monopolistic competition has characteristics
in common with both perfect competition and monopoly (hence the hybrid name).
Like perfect competition, monopolistic competition has multiple firms and easy entry.
Therefore, the long-run result is the same as perfect competition (normal profit). As in
monopoly, firms in monopolistic competition sell a unique (or at least differentiated)
product and have some control over price. Therefore, they can earn a profit in the short
run by differentiating their product.
Engage students in a debate about whether a monopolistically competitive industry is
inefficient. Discuss the two possible points of inefficiency: firms sell for a price greater
than marginal cost, and produce at a point where average total cost is not minimized,
suggesting there is excess capacity. Now point out a benefit of monopolistic competition:
more choice for consumers.
Common Student Pitfalls
• Confusion over the term “Monopolistic”. Students may confuse monopolistic
competition with monopoly. Explain that the “monopolistic” aspect of monopolistic competition means that firms attempt to convince consumers that they have a
unique product.
Case Studies in the Text
Economics in Action
The Housing Bust and the Demise of the 6% Commission—This EIA explains how the use
of real estate agents to buy and sell houses fits the model of monopolistic competition
and how recent changes have affected the tradition of 6% commissions on the sale of
a house.
Ask students the following questions:
1. How were real estate agents able to prevent competition from lowering
the standard 6% commission on house sales for so long? (Control of the
multiple listing system.)
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2. What recent changes have led to an increase in discount real estate agencies? (The Justice Department and Federal Trade Commission have fought
anticompetitive tactics and excessive profits generated during the real
estate boom.)
Activities
Who’s Profitable? (3–5 minutes)
Put these three graphs on the board. Ask students to characterize the firm as earning
economic profits, having break-even profit, or bearing losses.
(a. economic profit; b. loss; c. break-even profit)
(a)
Price
(b)
Price
MC
P
MC
ATC
P
ATC
D
Q
MR
Quantity
(c)
Price
MC
P
ATC
D
Q
MR
Quantity
D
Q
MR
Quantity