Module 67: Introduction to Monopolisitic Competition

Module 67: Introduction to Monopolisitic Competition Schmidty School of Economics

Learning Targets I Can

Key Economic Concepts For This Module: Firms in monopolistic competition have downward sloping demand curves because their products are differentiated from the product of their rivals. This gives firms some pricing power, and firms maximize profit by setting output where MR=MC. In the short run, firms can earn economic profits if P>ATC, or can incur losses if P<ATC. In the long run, entry and exit causes firms to earn normal profits. Long-run equilibrium occurs at an output where P=ATC and the demand curve is tangent to the ATC curve. Because firms do not produce the level of output where ATC is minimized, it is said that monopolistically competitive markets have excess capacity. Because price exceeds marginal cost, deadweight loss exists, but this inefficiency is offset by the many diverse products from which consumers can choose

Module Layout I. Understanding Monopolistic Competition A. Monopolistic Competition in the Short Run B. Monopolistic Competition in the Long Run II. Monopolistic Competition versus Perfect Competition A. Price, Marginal Cost, and Average Total Cost B. Is Monopolistic Competition Inefficient?

I. Understanding Monopolistic Competition This market structure shares characteristics with both perfect competition and monopoly. A quick review of those characteristics: Many firms exist in the market, but not as many as perfect competition (dozens vs. thousands). The product is differentiated. Each firm has some ability to set the price of their product. There are no barriers to entry or exit. Unlike oligopoly, there is little opportunity for tacit collusion as there are too many firms in the industry for it to be successful. The only real opportunity for strategic behavior is to advertise to consumers the message that their differentiated product is better than the similar, but different, rival products. A good example of monopolistic competition is the local market for restaurants, retail groceries or clothing stores.

A. Monopolistic Competition in the Short Run Because firms have a differentiated product, the demand for their product is downward sloping. The firm maximizes profit the same way all of the other firms do: Q where MR=MC The price is found by going vertically to the demand curve. The rectangle of profit is found by locating ATC at the output Q. These profits and/or losses in the short run will not last in the long run because it is easy for firms to enter and exit monopolistic competition in the long run.

B. Monopolistic Competition in the Long Run Short-run profits attract entry into the market. Demand and marginal revenue for existing firms products declines (shifts to the left), as there are more similar products available to the same number of consumers. A weaker demand causes prices to fall. Lower prices cause economic profits to fall (the profit rectangle is getting smaller). Entry stops when normal profits are made (firms are breaking even). Duffka School of Economics-67

B. Monopolistic Competition in the Long Run What does this mean? The only way for firms to break even is for P*=ATC so there is no profit or loss rectangle. Since price comes from the demand curve, the only way for P=ATC is for the demand curve to touch ATC at the output Q, where MR=MC. In our graph, the only place where this happens is where the downward-sloping demand curve is just tangent to the U-shaped ATC curve at the output Q.

II. Monopolistic Competition versus Perfect Competition Perfect Competition The long-run level of output is where P=MR=MC=ATC. Economic profits are zero; a normal profit is earned. Demand is horizontal to the firm. Monopolisitic Competition The long-run level of output is where P=ATC>MR=MC. Economic profits are zero; a normal profit is earned. Demand has a negative slope. Duffka School of Economics-67

II. Monopolistic Competition versus Perfect Competition ü Another difference, referred to as excess capacity, between the two market structures. ü In monopolistic competition, firms do not produce the level of output at which ATC is minimized ü By extension, the entire industry does not produce these products at the lowest possible cost.

B. Is Monopolistic Competition Inefficient? ü In the Monopoly module, we saw that deadweight loss exists when output stops prior to the point where P=MC. Any time price is not equal to marginal cost, efficiency can be improved. ü In monopolistic competition, P>MC so deadweight loss exists, and inefficiency exists. Because there is more competition for consumers, the wedge between price and marginal cost is lower in this market structure than it was in monopoly, so the degree of DWL is smaller in monopolistic competition. ü Can we live with some DWL? ü Probably. After all, the reason why P>MC is because firms have differentiated products that allows them some degree of pricing power similar to, but not as significant as, a monopolist. ü This DWL might be called the price of variety. The monopolistically competitive restaurant industry is much preferred (though inefficient) to the perfectly competitive version where all menus are the same.

Practice Question #1 1. Which of the following is a characteristic of monopolistic competition?a. a standardized productb. many sellersc. barriers to entryd. positive long-run profitse. a perfectly elastic demand curve

Practice Question #2 2. Which of the following results is possible for a monopolistic competitor in the short run? I. positive economic profit II. normal profit III. lossa. I onlyb. II onlyc. III onlyd. I and II onlye. I, II, and III

Practice Question #3 3. Which of the following results is possible for a monopolistic competitor in the long run? I. positive economic profit II. normal profit III. lossa. I onlyb. II onlyc. III onlyd. I and II onlye. I, II, and III

Practice Question #4 4. Which of the following best describes a monopolistic competitor s demand curve? a. upward slopingb. downward slopingc. U- shapedd. horizontale. vertical

Practice Question #5 5. The long-run outcome in a monopolistically competitive industry results ina. inefficiency because firms earn positive economic profits.b. efficiency due to excess capacity.c. inefficiency due to product diversity.d. efficiency because price exceeds marginal cost.e. a trade-off between higher average total cost and more product diversity.

2007 Free Response (B) 1. Assume that the cellular telephone company industry is monopolistically competitive. a. Assume that cellular manufacturers are earning short-run economic profits. Draw a correctly labeled graph for a typical firm in the industry and show each of the following. i. The profit maximizing output and price ii. The area representing economic profit (b) At the profit-maximizing price you identified in part (a), would the typical firm s demand curve be price inelastic? Explain. (c) Given the information in part (a), what happens to the demand curve for the typical firm in the long run? Explain. (d) Using a new correctly labeled graph, show the profit-maximizing output and price for the typical firm in the long run. (e) Does the typical firm produce an output level that minimizes its average total cost in the long run? (f) In long-run equilibrium, does the typical firm produce the allocatively efficient level of output? Explain.

2007 Free Response (B) (b) At the profit-maximizing price you identified in part (a), would the typical firm s demand curve be price inelastic? Explain. 2 Points: ONE Point: Stating that it is price elastic (or No ). ONE Point: Explanation that MR is positive so TR rises if P is decreased

2007 Free Response (B) (c) Given the information in part (a), what happens to the demand curve for the typical firm in the long run? Explain. 2 Points: ONE Point: Stating that the demand curve for the typical firm would shift to the left. ONE Point: For the explanation that the entry of new firms reduces the market share (demand) of existing firms.

2007 Free Response (B) (d) Using a new correctly labeled graph, show the profit-maximizing output and price for the typical firm in the long run. ONE Point: Showing that long-run equilibrium occurs at the tangency of ATC and the demand curve at the profit-maximizing quantity.

2007 Free Response (B) (e) Does the typical firm produce an output level that minimizes its average total cost in the long run? ONE Point: No

2007 Free Response (B) (f) In long-run equilibrium, does the typical firm produce the allocatively efficient level of output? Explain. TWO Points: ONE Point: No ONE Point: Explanation that at the long-run equilibrium, P>MC.