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Chapter 25: Monopolistic Competition. CHARACTERISTICS. Relatively Large Number of Sellers Small Market Shares No Collusion (collusion needs few producers) Independent Action (each firm sets its price without considering the possibility of rival reactions) 2) Differentiated Products
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Chapter 25: Monopolistic Competition
CHARACTERISTICS • Relatively Large Number of Sellers • Small Market Shares • No Collusion (collusion needs few producers) • Independent Action (each firm sets its price without considering the possibility of rival reactions) • 2) Differentiated Products • Product Attributes, Service, Location (accessibility), • Brand Names and Packaging, Some Control Over Price • 3) Role of Advertising • To differentiate their products (Non-price competition) • 4) Easy Entry and Exit (relative to monopoly) • Relatively small, don’t heavily rely on economies of scale.
Price and Output in Monopolistic Competition The firm’s demand curve The firm faces a highly, but not perfectly, elastic demand curve. Reasons: • The seller has many competitors. • Close substitutes to its product. Elasticity of demand for the producer depends on: • The number of rivals (+) • The degree of product differentiation (-)
Optimal Output: The Short Run Rule: MC = MR There are tow possibilities: • Profit • Losses Optimal Output: The long run: Only a Normal Profit (i.e. economic profit = zero)
Profits: Firms enter. • In the short run economic profits attract new entrants. • Demand facing the firm shifts to the left • Profits decline • Demand curve is tangent to ATC • No further incentive for entry
Losses: Firms leave • In the short run economic losses force some firms to leave • Demand facing the firm shifts to the right • losses disappear • Demand curve is tangent to ATC • No further incentive to exit
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC ATC P1 A1 Price and Costs Economic Profits D MR New competition drives down the price level – leading to economic losses in the short run Q1 Quantity
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC ATC A2 P2 Economic Losses Price and Costs D MR With economic losses, firms will exit the market – Stability occurs when economic profits are zero Q2 Quantity
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC Long-Run Equilibrium Normal Profit Only ATC P3 = A3 Price and Costs D MR Q3 Quantity
MONOPOLISTIC COMPETITIONAND EFFICIENCY In Pure Competition only • Economic Efficiency: P = MC = Minimum ATC • Productive Efficiency: P = ATC Goods are produced in the least costly way. Price is just efficient to cover total costs including a normal profit • Allocative Efficiency: P = MC The right amount of output is being produced. The right amount of the society’s scarce resources is being devoted to this specific use.
MONOPOLISTIC COMPETITION AND EFFICIENCY • In Monopolistic Competition • Not Productively Efficient: • price Minimum ATC • P > Minimum ATC • Not Allocatively Efficient: • Price MC
Monopolistic competition results in underallocation of the society’s resources. • Monopolistic competition is not allocatively efficient. • Consumers pay a higher than the competitive price and obtain a less than optimal output. • Monopolistic competition producers must charge a higher than the competitive price in the long run in order to achieve a normal profit. • The price-marginal cost gap experienced by each firm creates an industrywide efficiency loss.
Excess Capacity • Optimal capacity is to produce at minimum ATC. • The gap between minimum ATC and the profit maximizing price identifies excess capacity: • Plant and equipment are underused because production is at less than minimum ATC.
Price is Not = Minmum ATC Price MC MONOPOLISTIC COMPETITION AND EFFICIENCY MC Long-Run Equilibrium ATC P3 = A3 Price and Costs D MR Excess capacity Q3 Q4 Quantity