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Economics 1021A/B Lecture Notes - Opportunity Cost, Monopolistic Competition, Marginal Revenue

Course Code
ECON 1021A/B
Jeannie Gillmore

of 5
Chapter 14 Notes
Monopolistic Competition
a large number of firms compete
o each firm has a small market share
each firm has only limited power to influence the price of its product
each firm’s price can deviate from the average price of other firms by
only a relative small amount
o ignore other firms
firms do not pay attention to any one individual competitor
no firm can dictate market conditions, so no one firm’s actions directly
affect the actions of the other firms
o collusion impossible
firms in monopolistic competition would like to be able to conspire to
fix a higher price (collusion)
because the number of firms in monopolistic is large, coordination is
difficult and collusion is not possible
each firm produces a differentiated product
o product differentiation is the production of a slightly different product
compared to competing firms
differentiated product is a close substitute, but not a perfect substitute
for the products of other firms
when the price of one variety increases, quantity demanded decreases,
but not necessarily decreases
firms compete on product quality, price, and marketing
o the quality of the product is the physical attributes that make it different from
the products of other firms
o because of product differentiation, a firm in monopolistic competition faces a
downward-sloping demand curve a firm can set both its price and output
a firm can only charge a high price with a high quality product
o firms must market products due to product differentiation
firms that produce a high quality product (and want to sell it at a high
price) must advertise and package that product in way that convinces
buyers that they are getting the higher quality for which they are
paying for
low-quality producers use advertising and packaging to persuade
buyers that although quality is low, price compensates for this
firms are free to enter and exit the industry
o no barriers to prevent new firms from entering an industry in the long run,
thus no economic profit made by a firm in the long run
o entry occurs when firms currently experience economic profit
lowers prices and eliminates profit
o exit occurs when firms experience economic loss
increase prices and eliminates economic loss
o in the long run, firms neither enter nor leave the industry and the firms in the
industry make zero economic profit
Price and Output
in the short run, a firm in monopolistic
competition produces where marginal revenue
equals marginal cost
economic profit occurs when the profit
maximizing quantity occurs at a point where
ATC is less than demand
economic loss results when ATC is greater than
demand at the profit maximizing quantity
Economic Profit in the Long Run
as firms enter a profitable industry, the demand
for one firms product decreases
o demand curve and marginal revenue curve shift leftward
profit maximizing quantity and price fall
in the long run, average total cost equals demand, and the demand curve is tangent to
the average total cost curve
Monopolistic Competition and Perfect Competition
excess capacity
o a firm has excess capacity if it produces below its efficient scale, which is the
quantity at which average total cost is a minimum
o average total cost is the lowest possible only in perfect competition
o firms in monopolistic competition have excess capacity, as they could sell
more by cutting their prices (but would incur losses)
o a firm’s markup is the amount by which price exceeds marginal cost
o in perfect competition, a price always equals marginal cost and there is no
o in monopolistic competition, buyers pay a higher price than in perfect
competition and also pay more than marginal cost
Efficiency in Monopolistic Competition
resource are used efficiently when marginal social benefit equals marginal social cost
o price equals marginal social benefit and the firm’s marginal cost equals
marginal social cost
in long run equilibrium in monopolistic competition, price does exceed marginal cost
people value variety, because it provides an external benefit
o infinite variety isn’t seen as it is costly
each different variety of any product must be designed, and then
consumers must be informed about it
the costs of design and marketing (setup costs) mean that some
varieties that are too close to others already available are just not worth
the efficient degree of product variety is the one for which the marginal social benefit
of product variety equals its marginal social cost
o the loss that arises because the quantity produced is less than the efficient
quantity is offset by the gain that arises from having a greater degree of
product variety
o compared to the alternative (product uniformity), monopolistic competition
might be efficient
Innovation and Product Development
to maintain economic profits, firms must continually seek ways of keeping one step
ahead of imitators (other firms that imitate the success of profitable firms)
o one major way of trying to maintain economic profit is for a firm to seek out
new products that will provide it with a temporary competitive edge
a firm that introduces a new and differentiated product faces a demand
that is less elastic and is able to increase its price and make an
economic profit
eventually, imitators will make close substitutes for the innovate
product and compete away the economic profit arising from an initial
to restore economic profit, the firm must again innovate
profit-maximizing product innovation
o innovation and product development are costly activities, but they also bring
in additional revenues
the firm must balance the cost and revenue at the margin
o the marginal dollar spent on developing a new or improved product is the
marginal cost of product development
o the marginal dollar that the new or improved product earns for the firm is the
marginal revenue of product development
o at a low level of product development, the marginal revenue of a better
product exceeds the marginal cost
o at a high level of product development, the marginal cost of a better
product exceeds the marginal revenue