ECON3200 Class6 Monopolistic Competition

Industrial Organization AS/ECON 3200
Class 6: Monopolistic competition

Andrey Stoyanov
andreyst@yorku.ca
Andrey Stoyanov (andreyst@yorku.ca) Industrial Organization AS/ECON 3200 1 / 27
Readings
Chapter 7 Monopolistic competition
Introduction (pp.200-202)
Dierentiated products and the eect on a rms demand curve
(pp.202-205)
The representative consumer model (pp.206-214)
A representative consumer model with dierentiated products
(pp.214-215)
Welfare with dierentiated products and xed costs eect
(pp.215-218)
Suggested textbook problems: #1, #2, #5, #6.
Introduction
Monopolistically competitive markets combine elements of the
monopoly and of the perfect competition.
As in the case of a monopoly, rms in monopolistically competitive
markets have market power. They face a downward sloping (residual)
demand function for their product and can charge prices above
marginal costs
As in perfect competition, there are no entry barriers so that rms
make zero economic prots in the long run.
Introduction
How a rm can face a downward sloping demand function for its
product with free entry? Why it will not be at, as in perfectly
competitive (PC) markets?
One reason is the assumption of homogeneous products we imposed
for PC. When consumers value dierent brands dierently, rms may
increase their price without losing all of their customers.
Another reason for downward sloping demand function is the presence
of xed costs and lack of price-taking behavior. In this class we
discuss two models of monopolistic competition. First, we will keep
the assumption of homogeneous products. Then, well look at
monopolistically competitive markets where rms produce
dierentiated products.
Denition and assumptions
Assumptions of a monopolistically competitive market with
homogeneous products:
1
Free market entry - new rms enter whenever they can make positive
economic prot
2
Firms produce homogeneous products
3
Firms have market power - they can set prices above their marginal
costs
4
Firms compete in quantities
5
Increasing return to scale
_
falling average costs:
AC(q)
q
< 0
_
Assumptions 2 and 4 were used in all previous market structure models
(Monopoly (M), perfect competition (PC), Cournot Oligopoly (CO)).
Assumption 1 is specic to PC, and Assumption 3 is specic to M and CO.
Firms output strategies
To make our analysis compatible with previous models, lets also keep
the same assumption about industry cost and demand structure:
Market demand function D
M
: Q
d
= 1000 1000p
Total costs of one rm: TC(q) = 0.28q + 6.4
Note that total costs here has a constant component that reects
presence of xed costs: FC = 6.4. From TC function we can nd
MC = 0.28 and ATC(q) = 0.28 +
6.4
q
. Average costs are falling with
output, so we have increasing return to scale production technology.
What will be an equilibrium output strategy of, for example, Firm 1 if
its cost structure is as above and if it believes that the rest of the
industry produce Q
I
units of output?
Firm 1 output strategies
See Figure 1 on the next slide
If Firm 1 believes that all other rms in the industry together produce
Q
I
, then its residual demand function becomes RD
1
(q
1
) = Q
d
Q
I
Knowing the residual demand function, the rm acts as a monopolist
on this function. As a monopolist, it picks the combination of price
and output from RD
1
that maximizes Firm 1 prots. This is why the
competition in this market called monopolistic.
The prot-maximizing output level q
1
of Firm 1 is where MR = MC,
and the equilibrium price is determined from the residual demand
function p
= RD
1
(q
1
)
Therefore, given the residual demand function, the prot-maximizing
output strategy of monopolistically competitive rm is exactly the
same as that of Cournot oligopolists.
Firm 1 output strategies graphically
Market equilibrium
In Figure 1, p
> MC and as a result Firm 1 is making positive

economic prot of $
1
Positive economic prot means that other opportunities for Firm 1 are
less protable, i.e. its accounting prot will be lower in other markets.
The same is true for rms operating in other markets: they could get
higher prots in this market, as long as entry barriers are zero.
Therefore, in the long run new rms will enter until
1
= 0
Entry of new rms means that the total output by the rest of the
industry (from Firm 1 perspective) will increase from Q
I
to
_
Q
I
+q
new
_
, where q
new
is the output by new rms.
Therefore, the residual demand function
RD
1
(q
1
) = Q
d
_
Q
I
+q
new
_
will shift further to the left.
New entry (and the leftward shift of the residual demand function)
will continue until
1
= 0.
The equilibrium strategy of Firm 1 and market equilibrium are shown
on Figure 2.
Market equilibrium
Market equilibrium
The only strategy that maximizes Firm 1 prots is point A. This
strategy gives zero prot but any other strategy will lead to losses.
Given the shape of ATC and RD
1
, producing more/less than q
1
will
lead to losses since for q > q
1
or for q < q
1
we have ATC > p
and
negative prots, as opposed to zero prots at q
1
Therefore, only at point A where RD
1
is tangent to ATC we can have
2 conditions satised together: Firm 1 has zero prot; Firm 1 acts as
a prot maximizer.
Since q
1
is the prot-maximizing output level, it must be the case
that MR crosses MC at q
1
, as shown on the diagram.
Numerical solution to the model with homogeneous
products
The monopolistically competitive equilibrium must satisfy two
equilibrium conditions
First, each rm has to choose the output level that maximizes its
prot. For Firm 1 this implies:
1
=
_
1
q
1
+q
2
+ ... +q
N
1000
_
. .
p
q
1
0.28 q
1
6.4
FOC :

1
q
1
= p
1
1000
q
1
0.28 = 0 (1)
Second, in the presence of free entry, each rm has to make zero
prot:
p q
1
0.28 q
1
6.4
. .
1
= 0 (2)
Numerical solution to the model with homogeneous
products
The system of equations (1) and (2) has two equations with two
unknowns (p and q
1
). Solving this system, we obtain the market price
and rm-level output that maximize rm-level prot and ensure zero
economic prot:
p
= 0.36
q
1
= 80
Again, since all rms are symmetric in terms of costs, they have the
same output strategy: q
1
= q
2
= ... = 80
Finally, we can nd the equilibrium number of rms N from the
market demand, substituting the equilibrium price p
and the total

industry output N q
1
into it:
Q
d
= 1000 1000p ) N 80 = 1000 1000 0.36 ) N
= 8
Change in xed costs
If xed costs get lower for whatever reason, the ATC curve will fall.
With the old residual demand function, each rm will start making
positive prot, which will attract new rms into this market.
When new rms start to enter, the total industry output will increase,
shifting the residual demand function of each rm leftward, until it
touch a new ATC curve at a single point.
At this new equilibrium, the equilibrium output and price of each rm
will decreasee. Since with lower price consumers will demand more,
the number of rms must increase in order to satisfy the growing
demand.
Welfare analysis
There are two reasons why monopolistically competitive markets are
inecient
First, each rm produces less than the welfare-maximizing level of
output (which is at the level where p = MC). Since p > MC, extra
unit of output has greater value for consumers than its marginal cost
of production, and the welfare from producing an additional unit of
output will increase
Second, the number of rms is too big. Each rm has to pay xed
costs of 6.4. With 8 rms the total burden of xed costs for the
society is 8 6.4 = 51.2. One rm can produce the same output level
as 8 rms but with xed costs of only 6.4.
Therefore, the welfare-maximizing equilibrium will be a single rm
pricing at the level of p = MC.
Welfare analysis and governmental policy
If the government wants to achieve the welfare-maximizing market
outcome, it has to restrict the entry of new rms and allow only one
rm to serve the whole market at the price equal to marginal costs.
Essentially, the market will become a monopoly with regulated price.
However, achieving a welfare-maximizing outcome is practically
impossible for the government for two reasons. First, at p = MC the
rm suers losses and has to be subsidized. Second, it will be very
dicult/impossible to force a single rm (monopolist) to price at the
level of MC because we know that the monopolist tends to charge
prices well above MC.
Introduction
In monopolistically competitive markets rms face downward-sloping
residual demand function and earn zero economic prot as a result of
free entry.
One reason why the residual demand function is downward-sloping
instead of being at, as in the case of perfectly competitive markets,
is the presence of xed costs of production together with price-setting
behavior of rms in the market (as opposed to price-taking behavior
by perfectly competitive rms). This case was covered in previous
class.
Another reason why the residual demand curve may be downward
sloping in the presence of free market entry is product dierentiation.
If rms produce dierent varieties of the same product, they may
charge dierent prices and stay in the market.
Product dierentiation
How substitutability of dierent varieties may aect rms residual
demand function?
With higher degree of product dierentiation, the residual demand
function faced by each rm in the market gets steeper. Consider two
extreme cases. On one side, when products are perfect substitutes to
each other, the market becomes perfectly competitive and the
residual demand function for each rm is at. On the other side,
when products are completely dierentiated, each rm becomes a
monopolist since consumers cannot switch from one supplier of a
good to another.
In general, when we move away from perfect homogeneity towards
complete dierentiation, residual demand functions of rms in that
industry become more insulated and their market power becomes
greater (gets closer to monopolys market power).
Demand function for dierentiated products
Two rms produce dierent varieties of the same product if consumers
believe these products are dierent. Without product dierentiation it
will not matter for consumers which brand of the product to buy.
In all industries rms produce dierent varieties of the product. What
matter is the degree of dierentiation between these varieties.
Usually, we measure the degree of dierentiation with the concept of
substitutability. Highly dierentiated products that have many
dierent characteristics are bad substitutes to each other. More
homogeneous products are good substitutes (consumers can more
easily switch brands and get the similar product/service).
Product dierentiation is important for the analysis of market
equilibrium because its aects the shape of the rms residual demand
function.
Usually, how much rm i can sell at any given price depends on how
much other rms sell in the market: p
i
= D (q
1
, q
2
, ..., q
N
), where D
is the inverse residual demand function.
When products are homogeneous, then what matters for rms i
residual demand function is how much of the product is produced by
the whole industry (Q): p
i
= D (Q) = D (q
i
+Q
i
), where Q
i
is
the total output produced by all rms in the industry other than rm
i , so that (q
i
+Q
i
) = Q.
For linear demand function and homogeneous products, we can write
the residual demand function for rm i as:
p
i
= a bQ = a b (q
i
+Q
i
)
What will be the residual demand function if rm i produce a good that is
slightly dierent from (imperfect substitute for) what other rms produce in
that industry?
If rms produce dierent varieties of the same product, consumers view
these products as imperfect substitutes to each other. As a result, the
responsiveness of price with respect to rms own output will be dierent
from the responsiveness of price with respect to the output of all other rms.
With linear demand function, this is equivalent to having dierent slopes for
q
i
and for Q
i
: p
i
= a b
1
q
i
b
2
Q
i
, where b
1
> b
2
.
The degree of dierentiation can be captures by the following measure:
DD =
(b
1
b
2
)
b
1
2 [0; 1]. If b
1
= b
2
(DD = 0), products are perfectly
homogeneous and rms cannot charge dierent prices (perfect competition).
If b
2
= 0 (DD = 1) markets are perfectly dierentiated (that is, rms
produce completely dierent products), and each faces no competition from
other rms and becomes a monopolist.
Cournot oligopoly with dierentiated products
How does the Cournot oligopoly market equilibrium and strategies
would change if we allow for product dierentiation?
Lets take the same numerical example as we used for Cournot
oligopoly. There are N rms with TC = 0.28q + 6.4.
To allow for product dierentiation, suppose that the residual demand
function of each rm i is p
i
= 1
q
i
1000

Q
i
2000
so that the price is
twice less sensitive to changes in Q
i
than to changes in rms own
output q
i
Lets look at the output strategy that maximizes prot function of Firm 1:
1
=
_
1
q
1
1000

q
2
+ .. +q
N
2000
_
. .
p
1
q
1
0.28 q
1
6.4
FOC:
1
1000
q
1
+
_
1
q
1
1000

q
2
+ .. +q
N
2000
_
0.28 = 0
Isolate for q
1
to obtain the best response function of Firm 1 to the output
by the rest of the industry:
q
1
= 360
q
2
+ ... +q
N
4
Comparing it to the case when products are homogeneous
(q
1
= 360
q
2
+...+q
N
2
), the best response function becomes less
responsive to strategies by other rms
Under the symmetry assumption, q
1
= q
2
= ... = q
N
, and the
optimum strategy becomes
q
1
= ... = q
N
=
1440
N + 3
If N = 2, each rm produce q
1
= q
2
= 288 and sets the price
p
1
= p
2
= 0.568. Both price and output are higher than in the case
of homogeneous products (0.52 and 240, respectively) so both rms
will make higher prot if they dierentiate their product from
products of other rms.
Note that with dierentiated products assymetric rms can charge
dierent prices and it is possible that p
1
6= p
2
in case of dierent cost
structure of two rms. With homogeneous products prices must be
equal, otherwise the rm with higher price lose all of its customers.
Since we move further away from perfectly competitive equilibrium,
product dierentiation with oligopolistic rms reduces national
welfare.
Monopolistic competition with dierentiated products
Monopolistic competition analysis with dierentiated products will
give the same equilibrium as with homogeneous products.
Prot-maximization condition:

1
q
1
= p
1
1000
q
1
0.28 = 0
Zero-prot condition: p q
1
0.28 q
1
6.4
. .
1
= 0
Both conditions are the same as with homogeneous product model,
therefore, the equilibrium price and output will be the same.
The reason for such a surprising result is the way we capture product
dierentiation in the residual demand function. The demand function
p
i
= 1
q
i
1000

Q
i
1000
(homogeneity) and p
i
= 1
q
i
1000

Q
i
2000
(dierentiation) have the same elasticity with respect to q
i
. This
material is beyond the level of this course and will not be tested.
Monopolistic competition with dierentiated products
However, monopolistically competitive markets with homogeneous
and dierentiated products have two important dierences.
Firstly, when rms produce dierentiated products they may charge
dierent prices for the same reason as oligopolistic rms with
dierentiated products.
Secondly, we cannot nd the total number of rms in monopolistically
competitive market if they produce dierentiated products. The
reason is that with dierentiated products we only observe rms
residual demand functions, while the market demand function simply
does not exist (see the notes on monopolistic competition with
homogeneous products on how to nd the number of rms in the
equilibrium).
Welfare analysis of monopolistic competition with
dierentiated products
As in the case with homogeneous products, there are two factors that
lead to welfare ineciency of monopolistically competitive markets.
First, as with homogeneous products, each rm sets the price above
marginal costs and produces less than the welfare-maximizing level of
output (which is at the level where p = MC).
Second, the number of rms may be either too big or too small. On
one hand, each additional rm has to pay additional xed costs of
production. On the other hand, each additional rm produces new
variety of the good and consumers are better-o when they have
more varieties to choose from.

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Industrial Organization AS/ECON 3200

Class 6: Monopolistic competition

> MC and as a result Firm 1 is making positive

and the total

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