2007 Thomson SouthWestern Monopolistic Competition Characteristics Many sellers

© 2007 Thomson South-Western

Monopolistic Competition • Characteristics: – Many sellers – Product differentiation – Free entry and exit – In the long run, profits are driven to zero Firms have some control over price © 2007 Thomson South-Western

What does the costs graph for one of these firms look like? © 2007 Thomson South-Western

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Short-Run vs. Long Run • Like competitive firms, the market adjusts in the short run until zero profits are earned in the long run © 2007 Thomson South-Western

The Monopolistically Competitive Firm in the Short Run • Two things can happen • A firm could experience economic loss • A firm could experience economic profit © 2007 Thomson South-Western

What if a firm is earning profit? © 2007 Thomson South-Western

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 © 2007 Thomson South-Western

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. © 2007 Thomson South-Western

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 © 2007 Thomson South-Western

What if a firm has short run losses? • Firms long run response will be to exit the market • Decreases the number of products offered. • Increases demand faced by the remaining firms until profit is driven to zero © 2007 Thomson South-Western

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 © 2007 Thomson South-Western

In the long run, firms will continue to enter and/or exit the market until a firm’s economic profit is driven to zero… © 2007 Thomson South-Western

The Long-Run Equilibrium • Two Characteristics • As in a monopoly, price exceeds marginal cost. • Causes deadweight loss • As in a competitive market, price equals average total cost. • Free entry and exit drive economic profit to zero. © 2007 Thomson South-Western

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 • Optimum production (efficient scale) is where MC = ATC © 2007 Thomson South-Western

Figure 3 Monopolistic versus Perfect Competition (a) Monopolistically Competitive Firm Price MC MC ATC P P = MC MR 0 (b) Perfectly Competitive Firm Quantity produced Efficient scale ATC P = MR (demand curve) Demand Quantity 0 Quantity produced = Efficient scale Quantity Excess capacity © 2007 Thomson South-Western

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. © 2007 Thomson South-Western

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. © 2007 Thomson South-Western

Deadweight Loss Price MC ATC P = ATC MR 0 Monopoly quantity Market efficient quantity Demand Quantity © 2007 Thomson South-Western

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. © 2007 Thomson South-Western