2007 Thomson South-Western

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2 Monopolistic Competition Characteristics: Many sellers Product differentiation Free entry and exit In the long run, profits are driven to zero Firms have some control over price

3 What does the costs graph for one of these firms look like?

4 3

5 Short-Run vs. Long Run Like competitive firms, the market adjusts in the short run until zero profits are earned in the long run

6 The Monopolistically Competitive Firm in the Short Run Two things can happen A firm could experience economic loss A firm could experience economic profit

7 What if a firm is earning profit? 2007 Thomson South-Western

8 Figure 1 Monopolistic Competition in the Short Run (a) Firm Makes Profit Price MC ATC Price Average total cost Profit Demand MR 0 Profitmaximizing quantity Quantity 2007 Thomson South-Western

9 Short Run Profits Encourage new firms to enter the market. This: Increases the number of products offered. Reduces demand faced by firms already in the market. Demand curves shift to the left. Profits decline.

10 Figure 2 A Monopolistic Competitor in the Long Run Price MC ATC P = ATC When profit is earned, firms will enter the market until profit is driven to zero 0 MR Profit-maximizing quantity Demand And this tangency lies vertically above the intersection of MR and MC. Quantity 2007 Thomson South-Western

11 What if a firm has short run losses? Firms long run response will be to exit the market Decreases the number of products offered. Increases demand faced by the remaining firms until profit is driven to zero

12 Figure 1 Monopolistic Competitors in the Short Run Price (b) Firm Makes Losses Losses MC ATC Average total cost Price MR Demand 0 Lossminimizing quantity Quantity 2007 Thomson South-Western

13 In the long run, firms will continue to enter and/or exit the market until a firm s economic profit is driven to zero

14 The Long-Run Equilibrium Two Characteristics As in a monopoly, price exceeds marginal cost. Causes deadweight loss As in a competitive market, price equals average total cost. Free entry and exit drive economic profit to zero.

15 Monopolistic versus Perfect Competition There is a noteworthy difference between monopolistic and perfect competition: Excess capacity The actual capacity (production) by a firm is less than what is optimum for the firm Optimum production (efficient scale) is where MC = ATC

16 Figure 3 Monopolistic versus Perfect Competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC P P = MC P = MR (demand curve) MR Demand 0 Quantity produced Efficient scale Quantity 0 Quantity produced = Efficient scale Quantity Excess capacity 2007 Thomson South-Western

17 Monopolistic versus Perfect Competition Excess Capacity There is no excess capacity in perfect competition in the long run. There is excess capacity in monopolistic competition in the long run. In monopolistic competition, output is less than the efficient scale.

18 Monopolistic Competition and the Welfare of Society There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.

19 Deadweight Loss Price MC ATC P = ATC MR Demand 0 Monopoly quantity Market efficient quantity Quantity

20 ADVERTISING 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. The firm is trying to shift their demand curve to the right to make more short-run profits.