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Western University
Economics 1021A/B
Michael Parkin

Nicole Wallenburg Economics Parkin Nov 23, 2011 Economics – Textbook Notes What is Monopolistic Competition? Monopolistic competition is a market structure in which:  A large number of firms compete  Each firm produces a differentiated product  Firms compete on product quality, price, and marketing  Firms and free to enter and exit the industry Large Number of Firms The presence of a large number of firms has three implications for the firms in the industry.  Small Market Share o Each firm supplies a small part of the total industry output o Each firm has only limited power to influence the price of its product  Ignore Other Firms o Must be sensitive to the average market price of the product, but the firm does not pay attention to any one individual competitor  Collusion Impossible o Would like to be able to conspire to fix a higher price – called collusion o Coordination is difficult and collusion is not possible Product Differentiation A firm practices product differentiation if it makes a product that is slightly different from the products of competing firms.  It would be a close substitute, but not a perfect substitute  Some people are willing to pay more for one variety of the product, so when its price rises, the quantity demanded of that variety decreases Competing on Quality, Price, and Marketing Product differentiation enables a firm to compete with other firms in three areas: product quality, price, and marketing.  Quality o The quality of a product is the physical attributes that make it different from the products of other firms o Quality included design, reliability, the service provided to the buyer, and the buyer’s ease of access to the product  Price o A firm in monopolistic competition faces a downward sloping demand curve o The firm can set both its price and output, but there is a trade off between the product’s quality and price  A firm that makes a high-quality product can charge a higher price than a firm that makes a low quality product Nicole Wallenburg Economics Parkin Nov 23, 2011  Marketing o Must market its product o Marketing takes two main forms: advertising and packaging o A firm that produces a high-quality product wants to sell it for a suitably high price  To be able to do so, it must advertise and package its product in a way that convinces buyers that they are getting the higher quality for which they are paying a higher price o A low quality producer uses advertising and packaging to persuade buyers that although the quality is low, the low price more than compensates for this fact Entry and Exit Monopolistic competition has no barrier to prevent new firms from entering the industry in the long run. A firm in monopolistic competition cannot make an economic profit in the long run  When existing firms make an economic profit, new firms enter the industry  When firms incur economic losses, some firms leave the industry in the long run Price and Output in Monopolistic Competition The Firm’s Short Run Output and Price Decision The demand curve tells us the quantity of a good demanded at each price, given the prices of there similar goods. It is not the demand curve for all of a good in general. The MR curve shows the marginal revenue curve associated with the demand curve for a good. The ATC curve and the MC curve show the average total cost and the marginal cost of producing a good.  It produces the output at which marginal revenue equals marginal cost Profit Maximizing Might be Loss Minimizing A firm might face a level of demand for its product that is too low for it to make an economic profit Long Run: Zero Economic Profit There is no restriction on entry into monopolistic competition, so if firms in an industry are making economic profit, other firms have an incentive to enter that industry. When all the firms in the market are making zero economic profit, there is no incentive for new firms to enter. If demand is so low relative to costs that firms incur economic losses, exit will occur. The exit process ends when all the firms in the market are making zero economic profit. Nicole Wallenburg Economics Parkin Nov 23, 2011 Monopolistic Competition and Perfect Competition There are two key differences between perfect competition and monopolistic competition:  Excess Capacity o A firm has excess capacity is it produces below its efficient scale, which is the quantity at which average total cost is a minimum – the quantity at the bottom of the U-shaped ATC curve  Examples: restaurants usually don’t fill their tables o Firms have excess capacity if they could sell more by cutting their prices, but then they would incur a loss
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