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Lecture 22

ECO100Y1 Lecture 22: Nov 20 - Monopolistic Competition

Course Code
Jack Carr

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Monopolistic Competition
Between Monopoly and Perfect Competition
- Perfectly Competitive Firm
oPrice always equals the marginal cost of production
oPrice equals average total cost
Because in the long run, entry and exit drive economic profit to zero
- Monopoly
oCan use market power to keep prices above marginal cost
Positive economic profit for the firm and deadweight loss for society
- Imperfect Competition
oIndustries that fall between cases of perfect competition and a monopoly
A market structure in which only a few sellers offer similar or identical
Small number of sellers makes rigorous competition less likely and
strategic interactions among them important
Economist’s measure a market’s domination by a small number of firms
with a statistic called the concentration ratio
The percentage of total output in the market supplied by the four
largest firms
Include industries such as breakfast cereal, aircraft manufacturing,
household laundry equipment, cigarettes, etc.
oMonopolistic Competition
A market structure in which many firms sell products that are similar but
not identical
Monopolistically competitive market departs from the perfectly
competitive ideal because each of the sellers a somewhat different product
Each firm has a monopoly over the product it makes
Markets with following attributes:
Many sellers
oMany firms competing for same group of customers
Product differentiation
oEach firm produces a product that is at least slightly
different from those of other firms
oEach firm faces a downward-sloping demand curve
Free entry and exit
oFirms can enter or exit the market without restriction
oNumber of firms in market adjusts until economic profits
are driven to zero
Type of Market Main Characteristic
Monopoly Only one firm
Oligopoly Only a few firms
Monopolistically Competitive Many firms but sell differentiated products
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Perfectly Competitive Many firms but sell identical products
Competition with Differentiated Products
The Monopolistically Competitive Firm in the Short Run
- Because product is different from those offered by other firms
faces a downward sloping demand curve
- Monopolist’s rule for profit maximization:
oChooses the quantity at which marginal revenue equals marginal costs and then
uses its demand curve to find the price consistent with that quantity
oFirm makes profit
Price exceeds average total cost
oFirm has losses
Price is below average total cost
The Long-Run Equilibrium
- When firms make profit
oNew firms have an incentive to enter the market
oEntry increases the number of products from which customers can choose
oReduces the demand faced by each firm already in the market
Profit encourages entry, and entry shifts the demand curves faced by the
incumbent firms to the left
As demand for incumbent firms’ products fall, firms face declining profit
- When firms have losses
oFirms in the market have an incentive to exit
oWith exit, customers have fewer products from which to choose
oDecrease in number of firms expands the demand faced by those firms that stay in
the market
Losses encourage exit, and exit shifts the demand curves of the remaining
firms to the right
As demand for remaining firms’ products rises, firms face rising profit
- Process of entry and exit continues until the firms in the market are making exactly zero
economic profit
oOnce market reaches long-run equilibrium, new firms have no incentive to enter
and existing firms have no incentive to exit
- Demand curve and Average Total Cost curve must be tangent once entry and exit have
driven profit to zero
oProfit per unit sold is the difference between price (found on demand curve) and
average total cost, the maximum profit is zero if these two curves touch without
- Long-Run Equilibrium Characteristics:
1. As in a monopoly, price exceeds marginal cost. This conclusion arises because
profit maximization requires marginal revenue to equal marginal cost and
because the downward-sloping demand curve makes marginal revenue less
than price.
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2. As in a competitive market, price equals average total cost. This conclusion
arises because free entry and exit drive economic profit to zero.
Monopolistic versus Perfect Competition
- Differences between monopolistic and perfect competition long-run equilibriums:
Monopolistically Competitive Perfectly Competitive
Excess Capacity
Entry and exit drive
each firm in a
competitive market
to a point of
tangency between its
demand and average
total cost curves
Shows that the quantity of output
at this tangency point is smaller
than the quantity that minimizes
average total cost
Firms produce on the downward-
sloping portion of their average
total cost curves
Produce below the efficient scale
Have Excess Capacity:
-Could increase the
quantity it produces and
lower average total cost of
- More profitable
Free entry in competitive markets
drives firms to produce at the
minimum of average total cost
Produce at the Efficient Scale
- Quantity that minimizes
average total cost of firm
Markup over
Marginal Cost
between price and
marginal cost.
Zero-profit condition
ensures only that P =
ATC. It doesn’t
ensure that P = MC.
Price > Marginal Cost
In long run equilibrium, operate
on the declining portion of their
average total cost curves, so
marginal cost is below average
total cost.
For price to equal average total
cost, price must be above
marginal cost. An extra unit sold
at price = more profits.
Price = Marginal Cost
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