Understanding Monopolistic Competition Dynamics

1. Chapter 25: Monopolistic Competition

2. 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.

3. 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 (-)

4. 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)

5. 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

6. 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

7. 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

8. 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

9. PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC Long-Run Equilibrium Normal Profit Only ATC P3 = A3 Price and Costs D MR Q3 Quantity

10. 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.

11. MONOPOLISTIC COMPETITION AND EFFICIENCY • In Monopolistic Competition • Not Productively Efficient: • price  Minimum ATC • P > Minimum ATC • Not Allocatively Efficient: • Price  MC

12. 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.

13. 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.

14. 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