ECON1211

INTRODUCTION
TO ECONOMICS
LECTURE 12
Monopolistic Competition
from MANKIW 2008; Ch. 16

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Monopolistic
competition
 Imperfect competition refers to
those market structures that fall
between perfect competition and
pure monopoly.

 Monopolistic Competition
 Many firms selling products that are
similar but not identical.
 Markets that have some features of
competition and some features of
monopoly.

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Characteristics of
monopolistic
competition
 Many sellers
 There are many firms competing for the same group of
customers e.g. books, cars, restaurants,
 Product differentiation
 Each firm produces a product that is at least slightly different
from those of other firms.
 Rather than being a price taker, each firm faces a downward-
sloping demand curve.
 Free entry and exit
 Firms can enter or exit the
market without restriction.

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Monopolistically
Competitive Firm
 Like a monopoly, monopolistically competitive firms
 have market power that permits pricing above marginal cost.
 level of sales depends on the price it sets.

 But …
 The presence of other brands in the market makes the demand for
your brand more elastic than if you were a monopolist.
 Free entry and exit impacts profitability.

 Therefore, monopolistically competitive firms have

limited market power.
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Monopolistic Competition:
Profit Maximization
 Maximize profits like a monopolist
 Produce output where MR = MC.
 Charge the price on the demand curve that corresponds to that
quantity.

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Short-Run Monopolistic
Competition
MC
$
ATC
Profit

PM
ATC

QM Quantity of
MR
Brand/Model X
1-6
Long Run Adjustments
 If the industry is truly monopolistically competitive, there is
free entry.
 In this case other “greedy capitalists” enter, and their new brands
steal market share.

 This reduces the demand for your product until profits are ultimately
zero.
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Long-Run Monopolistic
Competition
MC
$
AC

P*

MR
Q* Quantity of Brand
X
1-8
Long-Run Monopolistic
Competition

Long Run Equilibrium

(P = AC, so zero profits) MC
$
AC

P*

P1

Entry D

MR D1
Q1 Q* Quantity of Brand
MR1 X
1-9
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.

 But, there are two noteworthy differences between monopolistic

and perfect competition
①excess capacity
②mark-up.

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Monopolistic versus
Perfect Competition
① Excess Capacity
 There is no excess capacity in perfect competition in the
long run.
 Free entry results in competitive firms producing at the
point where average total cost is minimized, which is the
efficient scale of the firm.
 There is excess capacity in monopolistic competition in
the long run.
 In monopolistic competition,
output is less than the efficient
scale of perfect competition.

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Monopolistic versus Perfect
Competition
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC

P
P = MC P = MR
(demand
curve)

MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Excess capacity

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Monopolistic versus Perfect
Competition
② Mark-up Over Marginal
Cost
 For a competitive firm, price
equals marginal cost.
 For a monopolistically
competitive firm, price exceeds
marginal cost.
 Because price exceeds
marginal cost, an extra unit sold
at the posted price means more
profit for the monopolistically
competitive firm.

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 Monopolistic versus Perfect
Competition
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC
mark-up

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

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Copyright©2014 Cengage
Monopolistic Competition
and the Welfare of Society
 Monopolistic competition does not have all the
desirable properties of perfect competition.
 There is the normal deadweight loss of monopoly pricing in
monopolistic competition caused by the mark-up of price over
marginal cost.
 However, the administrative burden of regulating the pricing of
all firms that produce differentiated products would be
overwhelming.

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Monopolistic Competition
and the Welfare of Society
 Externalities of entry include:

 The product-variety externality:

 Because consumers get some
consumer surplus from the introduction
of a new product, entry of a new firm
conveys a positive externality on
consumers.

 The business-stealing externality:

 Because other firms lose customers and
profits from the entry of a new
competitor, entry of a new firm imposes
a negative externality on existing firms.

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Monopolistic Competition
The Good (To Consumers)
 Product Variety

The Bad (To Society)

 P > MC
 Excess capacity
 Unexploited economies of scale

The Ugly (To Managers)

 P = ATC > minimum of average costs.
 Zero Profits (in the long run)!

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Advertising and
branding
 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.
 Advertising behaviour of firms
 Firms that sell highly differentiated consumer
goods spend a lot on advertising.
 Firms that sell industrial products typically
spend very little on advertising.
 Firms that sell homogeneous products spend
nothing at all.

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The debate over advertising

 Critics of advertising argue that:

 Firms advertise in order to manipulate
people’s tastes.
 It impedes competition by implying that
products are more different than they
really are.
 Defenders argue that advertising:
 provides information to consumers
 increases competition by offering a
greater variety of products and prices.
 The willingness of a firm to spend
advertising dollars can be a signal to
consumers about the quality of the
product being offered.
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The debate over brand
names
 Critics argue that brand names cause consumers to
perceive differences that do not really exist.
 However, brand names may be a useful way for
consumers to ensure that the goods they are buying
are of high quality by:
 Providing information about quality.
 Giving firms incentive to maintain high quality.

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 Biting back at Apple
Sep 1st 2012

 Struggling smartphone-makers
 HTC, Nokia and BlackBerry fight to stay in the game

 Making mobile phones has always been an unforgiving, fast-

paced business.
 Consumers soon turn their backs if new models disappoint.

 Today’s smartphone business is less about specific devices

than about “ecosystems”, a combination of hardware,
operating system and applications.
 This is where Nokia and BlackBerr have lost out.

 As the smartphone stragglers fight for their long-term

survival, they can draw comfort from the fact that sometimes
there are second acts in the lives of tech firms.
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Global smartphone shipme
nts
Feb 1st 2014

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Key concepts of the
lecture
 Monopolistic competition
 Product differentiation
 Excess capacity
 Mark-up
 Advertising and brand names

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Exercise
 Michael Porter mentions two strategy options for
competing: the differentiation approach and the cost
leadership approach.
A. The differentiation approach implicates competing by
having a superior product. Relate this approach to the
monopolistically competitive model by using an
appropriate diagram. Justify your answer in less than 50
words.
B. The cost leadership approach implicates competing by
having a lower cost than one’s competitors. Relate this
approach to the monopolistically competitive model by
using an appropriate diagram. Justify your answer in less
than 50 words.
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