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Lecture 8

ECON 1000 Lecture Notes - Lecture 8: Monopolistic Competition, Product Differentiation, Sports Equipment

Course Code
ECON 1000
George Georgopoulos

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Lecture Eighteen: Monopolistic Competition
December 1, 2011
What is Monopolistic Competition?
Monopolistic competition is a market structure in which
-A large numbers of firms compete
-Each firm produces a differentiated product
-Firms compete on product, quality, price and marketing
-Firms are free to enter and exit the industry
Large Number of Firms
The presence of a large number of firms in the market implies
-Each firm has only a small market share and therefore has limited market
power to influence the price of its product
-Each firm is sensitive to the average market price, but no firm pays attention to
the actions of others.
-No one firm’s actions directly affects the actions of the others
-Collusion, or conspiring to fix prices, is impossible.
Product Differentiation
A firm in monopolistic competition practices product differentiation if the firm
makes a product that is slightly different from the products of competing firms.
Competing on Quality, Price and Marketing
Product differentiation enables firms to compete in three areas: quality, price
and marketing.
Quality includes design, reliability and service.
Because firms produce differentiated products, the demand for each firm’s
product is downward sloping
-There is a tradeoff between price and quality
Because products are differentiated, a firm must market its product
-Marketing takes two main firms: advertising and packaging
Entry and Exit
There are no barriers to entry in monopolistic competition, so firms cannot make
an economic profit in the long run.
Examples - producers of audio and video equipment, clothing, computers and
sporting goods all operate in monopolistic competition.
Price and Output in Monopolistic Competition
The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its marketing program
produces the profit-maximizing quantity at which its marginal revenue equals
its marginal cost.
Price is determined from the demand curve for the firm’s product and is the
highest price that the firm can charge for the profit-maximizing quantity.
Economic Profit in the Short Run
The firm in monopolistic competition operates like a single-price monopoly.
The firms produces the quantity at which MR equals MC and sells that quantity
for the highest possible price.
-It earns an economic profit when P > ATC
Profit Maximizing Might be Loss Minimizing
A firm might incur an economic loss in the short run
-At the profit-maximizing quantity, P < ATC is also possible
-At this point, the firm will incur an economic loss
Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
-Entry continues as log as firms in the industry earn an economic profit
-This is where P > ATC
In the long run, a firm in monopolistic competition maximizes its profit by
producing the quantity at which marginal revenue equals its marginal cost (MR =
As firms enter the industry, each existing firm loses some of its market share.
-The demand for its product decreases
-The demand curve for its product shifts leftward
The decrease in demand decreases the quantity at which MR = MC and lowers
the maximum price that the firm can charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC, and firms earn 0 economic
Monopolistic Competition and Perfect Competition
There are two key differences between monopolistic competition and perfect
-Excess capacity
A firm has excess capacity it it produces less than the quantity at which ATC is
a minimum.
A firm’s markup is the amount by which its price exceeds its marginal cost
Excess Capacity
Firms in monopolistic competition operate with excess capacity in long-run
Firms produce less than the efficient scale, which is the quantity at which ATC
is at a minimum.
The downward-sloping demand curve for their products drives this result.
Firms in monopolistic competition operate with positive markup.
Again, the downward sloping demand curve for their products drives this result.
To compare, firms in perfect competition have no excess capacity, and no
-The perfectly elastic demand curve for their products drives this result.
Is Monopolistic Competition Efficient?
Price equals marginal social benefit
-The firm’s marginal cost equals marginal social cost