Seventh Edition

Principles of
Economics

Wojciech Gerson (1831-1901)

N. Gregory Mankiw

CHAPTER Monopolistic
6 Competition
In this chapter,
look for the answers to these questions
• What market structures lie between perfect
competition and monopoly, and what are their
characteristics?
• How do monopolistically competitive firms choose
price and quantity? Do they earn economic profit?
• How does monopolistic competition affect society’s
welfare?
• What are the social costs and benefits of
advertising?
INTRODUCTION:
Between Monopoly and Competition
Two extremes
▪ Perfect competition: many firms, identical
products
▪ Monopoly: one firm

In between these extremes: imperfect competition

▪ Oligopoly: only a few sellers offer similar or
identical products.
▪ Monopolistic competition: many firms sell
similar but not identical products.

2
Characteristics & Examples of Monopolistic
Competition
Characteristics:
▪ Many sellers
▪ Product differentiation
▪ Free entry and exit
Examples:
▪ apartments
▪ books
▪ bottled water
▪ clothing
▪ fast food
▪ night clubs
3
 Comparing Perfect & Monop. Competition
Perfect Monopolistic
competition competition

number of sellers many many

free entry/exit yes yes

long-run econ. profits zero zero

the products firms sell identical differentiated

firm has market power? none, price-taker yes

downward-
D curve facing firm horizontal
sloping

4
 Comparing Monopoly & Monop. Competition
Monopolistic
Monopoly
competition
number of sellers one many

free entry/exit no yes

long-run econ. profits positive zero

firm has market power? yes yes

downward-
downward-
D curve facing firm sloping
sloping
(market demand)
close substitutes none many
5
A Monopolistically Competitive Firm Earning
Profits in the Short Run
The firm faces a
downward-sloping
D curve. Price
profit MC
At each Q, MR < P. ATC
P
To maximize profit,
ATC
firm produces Q D
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

6
A Monopolistically Competitive Firm
With Losses in the Short Run
For this firm,
P < ATC
Price
at the output where MC
MR = MC.
losses ATC
The best this firm
ATC
can do is to
minimize its losses. P

D
MR
Q Quantity

7
Monopolistic Competition and Monopoly
▪ Short run: Under monopolistic competition,
firm behavior is very similar to monopoly.
▪ Long run: In monopolistic competition,
entry and exit drive economic profit to zero.
▪ If profits in the short run:
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
▪ If losses in the short run:
Some firms exit the market,
remaining firms enjoy higher demand and prices.

8
A Monopolistic Competitor in the Long Run

Entry and exit

occurs until
P = ATC and Price
profit = zero. MC

Notice that the ATC

firm charges a P = ATC
markup of price markup
over marginal cost
D
and does not MC MR
produce at
minimum ATC. Q Quantity

9
Why Monopolistic Competition Is
Less Efficient than Perfect Competition
1. Excess capacity
▪ The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
▪ Under perfect competition, firms produce the
quantity that minimizes ATC.
2. Markup over marginal cost
▪ Under monopolistic competition, P > MC.
▪ Under perfect competition, P = MC.

10
Monopolistic Competition and Welfare
▪ Monopolistically competitive markets do not
have all the desirable welfare properties of
perfectly competitive markets.
▪ Because P > MC,
market quantity < socially efficient quantity.
▪ Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
to reduce prices.

11
Monopolistic Competition and Welfare
▪ Number of firms in the market may not be optimal,
due to external effects from the entry of new firms:
▪ The product-variety externality:
surplus consumers get from the introduction
of new products
▪ The business-stealing externality:
losses incurred by existing firms
when new firms enter market
▪ The inefficiencies of monopolistic competition are
subtle and hard to measure. No easy way for
policymakers to improve the market outcome.
12
ACTIVE LEARNING 1
Advertising
1. So far, we have studied three market structures:
perfect competition, monopoly, and monopolistic
competition. In each of these, would you expect
to see firms spending money to advertise their
products? Why or why not?
2. Is advertising good or bad from society’s
viewpoint? Try to think of at least one “pro” and
“con.”
Advertising
▪ In monopolistically competitive industries,
product differentiation and markup pricing
lead naturally to the use of advertising.
▪ In general, the more differentiated the products,
the more advertising firms buy.
▪ Economists disagree about the social value of
advertising.

14
The Critique of Advertising
▪ Critics of advertising believe:
▪ Society is wasting the resources it devotes to
advertising.
▪ Firms advertise to manipulate people’s tastes.
▪ Advertising impedes competition—it creates the
perception that products are more differentiated
than they really are, allowing higher markups.

15
The Defense of Advertising
▪ Defenders of advertising believe:
▪ It provides useful information to buyers.
▪ Informed buyers can more easily find and
exploit price differences.
▪ Thus, advertising promotes competition and
reduces market power.
▪ Results of a prominent study:
Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers
than in states that did not restrict such advertising.

16
Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts
on advertising may signal the quality of its product
to consumers, regardless of the content of ads.
▪ Ads may convince buyers to try a product once,
but the product must be of high quality for people
to become repeat buyers.
▪ The most expensive ads are not worthwhile
unless they lead to repeat buyers.
▪ When consumers see expensive ads,
they think the product must be good if the company
is willing to spend so much on advertising.
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Brand Names
▪ In many markets, brand name products coexist
with generic ones.
▪ Firms with brand names usually spend more on
advertising, charge higher prices for the products.
▪ As with advertising, there is disagreement about
the economics of brand names…

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The Critique of Brand Names
▪ Critics of brand names believe:
▪ Brand names cause consumers to perceive
differences that do not really exist.
▪ Consumers’ willingness to pay more for brand
names is irrational, fostered by advertising.
▪ Eliminating govt protection of trademarks
would reduce influence of brand names,
result in lower prices.

19
The Defense of Brand Names
▪ Defenders of brand names believe:
▪ Brand names provide information about quality
to consumers.
▪ Companies with brand names have incentive
to maintain quality, to protect the reputation of
their brand names.

20
CONCLUSION
▪ Differentiated products are everywhere;
examples of monopolistic competition abound.
▪ The theory of monopolistic competition
describes many markets in the economy,
yet offers little guidance to policymakers looking
to improve the market’s allocation of resources.

21
▪ A firm reports the following information about its price, MC,
and ATC. Can the firm possibly be maximizing profit? If not,
what should it do to increase profit? If the firm is profit
maximizing, is the firm in a long-run equilibrium? If not,
what will happen to restore long-run equilibrium?

A．P<MC， P MC
P>ATC ATC
B．P>MC， P = ATC
A B

P<ATC
D
C．P=MC， MC
MR
P>ATC QA QB Q
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A．In the monopoly market, each person's demand
for the product is q = 2-P, and the number of
consumers is n. solve for the market demand
equation and the marginal revenue, and draw
the demand and marginal revenue curve.
B. Suppose MC = 0 and FC = 0, solve for the profit
maximization Q, P and the profit and CS, PS.
C. Assuming that the enterprise must pay FC = 3
million yuan. How much should n be for the
enterprise chasing a maximal profit to pay FC
and produce the product? How much should n
be to be socially efficient?

23
q=2-P → Q=2N-NP
P
R=QP=2NP-
2
NP2=2Q-Q2/N
MR=2-2Q/N
A
1
MR=MC=0 →
Q=N,P=1 D

CS=0.5N PS=N MR MC
Q
Q=N≥300 N

socially efficient：
P=MC=0 →Q=2N-
NP=2N 24
Sleek Sneakers Co. is one of many firms in the market for shoes.
a. Assume that Sleek is currently earning shortrun economic profits.
On a correctly labeled diagram, show Sleek’s profit-maximizing output
and price, as well as the area representing profit.
b. What happens to Sleek’s price, output, and profit in the long run?
Explain this change in words, and show it on a new diagram.
c. Suppose that over time consumers become more focused on stylistic
differences among shoe brands. How would this change in
attitudes affect each firm’s price elasticity of demand? In the long run,
how will this change in demand affect Sleek’s price, output,
and profits?
d. At the profit-maximizing price you identified in part (c), is Sleek’s
demand curve elastic or inelastic? Explain.
25
 P
profit
Q：MR = MC P
MC ATC

P＞ATC，profit＞0 ATC
D

MR

Q Q

26
 P
In the SR，P＞ MC
ATC，positive ATC
profit P = ATC
A

More firm join

in →D shifts to D
MC
the left→P、Q↓， MR
until profit=0 QA Q

27
Consider a monopolistically competitive market with N firms. Each
firm’s business opportunities are described by the following equations:
Demand: Q = 100/N – P MR = 100/N – 2Q
TC = 50 + Q2 MC = 2Q
a. How does N, the number of firms in the market, affect each firm’s
demand curve? Why?
b. How many units does each firm produce? (The answers to this and
the next two questions depend on N.)
c. What price does each firm charge?
d. How much profit does each firm make?
e. In the long run, how many firms will exist in this market?

28
Summary
• A monopolistically competitive market has
many firms, differentiated products, and free
entry.
• Each firm in a monopolistically competitive
market has excess capacity—it produces
less than the quantity that minimizes ATC.
Each firm charges a price above marginal cost.
Summary
• Monopolistic competition does not have all of the
desirable welfare properties of perfect
competition. There is a deadweight loss caused
by the markup of price over marginal cost. Also,
the number of firms (and thus varieties) can be
too large or too small. There is no clear way for
policymakers to improve the market outcome.
Summary
• Product differentiation and markup pricing lead
to the use of advertising and brand names.
Critics of advertising and brand names argue
that firms use them to reduce competition and
take advantage of consumer irrationality.
Defenders argue that firms use them to inform
consumers and to compete more vigorously on
price and product quality.