Unit 9:

Monopolistic Competition
Instructor: Nguyen Tai Vuong
School of Economics and Management
Hanoi University of Science and Technology

Objectives
In this unit, 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?
• In what ways does monopolistic competition affect society’s
welfare?
• What are the social costs and benefits of advertising?

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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.

Characteristics & Examples of Monopolistic Competition

Characteristics:
• Many sellers
• Product differentiation
• Free entry and exit
Examples:
• apartments
• books
• bottled water
• clothing
• fast food
• night clubs
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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
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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
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MC Firm: Earning Profits in the Short Run
The firm faces a downward-
sloping D curve.
Price
At each Q, MR < P. profit MC
To maximize profit, firm P ATC
produces Q where MR = MC.
ATC
The firm uses the D
D curve to set P.
MR

Q Quantity

MC Firm: Losses in the Short Run

For this firm,
P < ATC
Price
at the output where MR = MC. MC
The best this firm can do is to losses ATC
minimize its losses.
ATC
P

D
MR
Q Quantity

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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.
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A Monopolistic Competitor in the Long Run

Entry and exit occurs until
P = ATC and profit = zero.
Notice that the firm Price
MC
charges a markup of price
over marginal cost and ATC
does not produce at P = ATC
minimum ATC.
markup
D
MC MR
Q Quantity

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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.

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Monopolistic Competition and Welfare

• Monopolistically competitive markets do not have all the

desirable welfare properties of perfectly competitive markets.

• Because P > MC, the market quantity is below the socially

efficient quantity.

• Yet, not easy for policymakers to fix this problem: Firms earn zero
profits, so cannot require them to reduce prices.

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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.

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A C T I V E L E A R N I N G 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.”

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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.

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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.

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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.

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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.

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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.

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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.

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SUMMARY
• A monopolistically competitive market has many firms, differentiated
products, and free entry.
• Each firm in a monopolistically competitive market has excess capacity –
produces less than the quantity that minimizes ATC. Each firm charges a
price above marginal cost.
• 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.
• 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.

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