R.

GLENN

HUBBARD
ANTHONY PATRICK

OBRIEN

FIFTH EDITION
2015 Pearson Education, Inc.

CHAPTER
CHAPTER

13

Monopolistic Competition:
The Competitive Model in
a More Realistic Setting

Chapter Outline and

Learning Objectives
13.1

Demand and Marginal Revenue for a

Firm in a Monopolistically
Competitive Market

13.2

How a Monopolistically Competitive

Firm Maximizes Profit in the Short
Run

13.3

What Happens to Profits in the Long

Run?

13.4

Comparing Monopolistic Competition

and Perfect Competition

13.5

How Marketing Differentiates

Products

13.6

What Makes a Firm Successful?

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Perfect Competition vs. Monopolistic Competition

The perfectly competitive markets in the previous chapter had the
following three features:
1. Many firms
2. Firms sell identical products
3. No barriers to entry to new firms entering the industry
The first two features implied a horizontal demand curve for individual
firms, while the third implied zero long-run profit.
Monopolistically competitive firms share features 1. and 3.; but their
products are not identical to their competitors.
So we expect monopolistically competitive firms to have zero long-run
profit, but not to face a horizontal demand curve.

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Demand and Marginal Revenue for a Firm in a

Monopolistically Competitive Market

13.1 LEARNING OBJECTIVE

Explain why a monopolistically competitive firm has downward-sloping demand

and marginal revenue curves.

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Monopolistic Competition
Monopolistic competition is a market structure in which barriers to
entry are low and many firms compete by selling similar, but not
identical, products.
The key feature here is that the products that monopolistically
competitive firms sell are differentiated from one another in some
way.
Example: Starbucks sells coffee, and competes in the coffee market
against other firms selling coffee.
But Starbucks coffee is not identical to the coffee that other firms sell.

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The Demand Curve for a Monopolistically Competitive Firm

Starbucks sells caff
lattes; while other firms
sell caff lattes also,
some people have a
preference for the
ones that Starbucks
sells.
If Starbucks raises the
price of its caff lattes,
it will lose some, but
not all, of its
customers.
Therefore Starbucks
faces a downwardsloping demand curve
for caff lattes.
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Figure 13.1

The downward-sloping
demand for caff lattes
at a Starbucks
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Marginal Revenue When Demand Is Downward-Sloping

CAFF LATTES
SOLD PER
WEEK (Q)

PRICE (P)

0
1
2
3
4
5
6
7
8
9
10

$6.00
5.50
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00

$0.00
5.50
10.00
13.50
16.00
17.50
18.00
17.50
16.00
13.50
10.00

The first two columns show the

demand schedule for Starbucks.

$5.50
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00

Table 13.1

$5.50
4.50
3.50
2.50
1.50
0.50
0.50
1.50
2.50
3.50

Demand and marginal

revenue at a Starbucks

Total revenue increases initially, then decreases; Starbucks has to

lower the price in order to sell additional caff lattes.
Hence marginal revenue is initially positive, then negative.
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How a Price Cut Affects Firm Revenue

When Starbucks
reduces the price
of a caff latte, it
can sell more
output.
Its revenue
increases because
of the additional
sale (at the new
price); this is the
output effect of the
price reduction.

Figure 13.2

How a price cut affects

a firms revenue

But its revenue decreases also. In order to sell the

additional caff latte, it must reduce the price on all cups it
will sell. The loss in revenue on the 5 cups it would have
sold anyway is the price effect of the price reduction.
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Marginal Revenue
Starbucks marginal
revenue for selling the
additional caff latte is
equal to the green area
minus the pink area:
the output effect minus
the price effect.
Since the output effect
is just equal to the
price, marginal
revenue is lower than
price.

Figure 13.2

How a price cut affects

a firms revenue

For any firm with a downward-sloping demand curve, the

marginal revenue curve must therefore be below the
demand curve.
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Demand and Marginal Revenue Curves

The graph shows the
Starbucks demand and
marginal revenue curves for
caff lattes.
After the 6th caff latte,
reducing the price in order to
increase sales results in
revenue decreasing
(negative marginal revenue);
the output effect (equal to
the height of the demand
curve) can no longer offset
the price effect (the vertical
difference between demand
and marginal revenue
curves).
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Figure 13.3

The demand and marginal

revenue curves for a
monopolistically competitive
firm
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How a Monopolistically Competitive Firm Maximizes

Profit in the Short Run

13.2 LEARNING OBJECTIVE

Explain how a monopolistically competitive firm maximizes profit in the short run.

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Profit Maximization
Just like a perfectly competitive firm, a monopolistically competitive
firm should not simply try to maximize revenue.
Each additional unit of output incurs some marginal cost.
Profit maximization requires producing until the marginal revenue
from the last unit is just equal to the marginal cost: MC = MR.
This same rule holds for all firms that can marginally adjust their
output.

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Profit Maximization Using a Table

The 1st, 2nd, 3rd, and 4th caff lattes

each increase profit: MC < MR.

Figure 13.4

Maximizing profit in a
monopolistically
competitive market

The 5th does not alter profit: MC = MR.

The 6th and subsequent caff lattes decrease profit: MC > MR.
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Profit Maximization Using Graphs

Figure 13.4 Maximizing profit in a

Starbucks sells caff lattes up until
monopolistically
MC = MR.
competitive market
This selects the profit-maximizing quantity. Then the demand curve
shows the price, and the ATC curve shows the average cost.
Since Profit = (P ATC) x Q, we can show profit on the graph with
the green rectangle.
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Identifying Profit Graphically

Be careful to perform these steps
in the correct order:
1. Use MC=MR to identify the
profit-maximizing quantity.
2. Draw a vertical line at that
quantity.
3. The vertical line will hit the
demand curve: this is the
price.
4. The vertical line will also hit
the ATC curve: this is the
average cost.

Figure 13.4b Maximizing profit in a

monopolistically
competitive market

5. The difference between price and

average cost is the profit (or loss) per unit.
6. Show the profit or loss with the rectangle with height (P ATC)
and length (Q* 0), where Q* is the optimal quantity.
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What Happens to Profits in the Long Run?

13.3 LEARNING OBJECTIVE

Analyze the situation of a monopolistically competitive firm in the long run.

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How the Entry of New Firms Affects Profits of Existing Firms

Figure 13.5

How entry of new firms

eliminates profits

Suppose demand is relatively high,

so that Starbucks can make a profit in the market for caff lattes.
This profit will attract new firms who will compete with Starbucks,
reducing the demand for Starbucks caff lattes.
Demand falls until, in the long run, no profit can be made: P = ATC.
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Monopolistic Competition: Short Run, Firm Making Profit

Relationship between Price
and Marginal Cost
Short Run
P > MC

Relationship between Price

and Average Total Cost
Short Run
P > ATC

Table 13.2a

Profit and Loss

Short Run
Economic profit

The short run and the long run for a

monopolistically competitive firm

In the short run, a monopolistically competitive firm might make a

profit or a loss.
The situation where the firm is making a profit is above.
Notice that there are quantities for which demand (price) is
above ATC; this is what allows the firm to make a profit.
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Monopolistic Competition: Short Run, Firm Making Loss

Relationship between Price
and Marginal Cost
Short Run
P > MC

Relationship between Price

and Average Total Cost
Short Run
P < ATC

Table 13.2b

Profit and Loss

Short Run
Economic loss

The short run and the long run for a

monopolistically competitive firm

Now the firm is making a loss.

Notice that there is now no quantity for which demand (price) is
above ATC; this firm must make a (short-run, economic) loss, no
matter what quantity it chooses.
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Monopolistic Competition: Long Run, Firm Breaking Even

Relationship between Price
and Marginal Cost
Long Run
P > MC

Relationship between Price

and Average Total Cost
Long Run
P = ATC

Table 13.2c

Profit and Loss

Long Run
Zero economic profit

The short run and the long run for a

monopolistically competitive firm

In the long run, the firm must break even.

Notice that the ATC curve is just tangent to the demand curve.
The best the firm can do is to produce that quantity.
There is no quantity at which the firm can make a profit; the ATC
curve is never below the demand curve.
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Zero Profit in the Long Run?

Our model of monopolistic competition predicts that firms will earn
zero profit in the long run.
However firms need not passively accept this long-run outcome. They
could:
Innovate so that their costs are lower than other firms, or
Convince their customers that their product/experience is better
than that of other firms, either by actually making it better in some
unique way, or making customers perceive that it is better, perhaps
through advertising.
Think of the long-run as the direction of trend; demand will continue
to fall to the zero (economic) profit level, unless the firm is able to do
something about it.

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Making The Rise and Decline and

the
Connection
From the mid-1990s to the mid-2000s,
Starbucks achieved strong profits by
differentiating its product and experience
from other coffeehouses.

Rise of Starbucks

As other firms started to mimic its experience,

Starbucks profitability went down.
By 2013, Starbucks had engineered a
turnaround, with innovations like wi-fi,
customization of drinks, a loyalty program,
smartphone-based payments, overseas
expansion, and higher-quality drinks.
But like all monopolistically competitive firms,
Starbucks will have to continue to innovate,
or the long-run outcome of zero economic
profit will catch up to it.
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Comparing Monopolistic Competition

and Perfect Competition

13.4 LEARNING OBJECTIVE

Compare the efficiency of monopolistic competition and perfect competition.

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Is Monopolistic Competition Efficient?

Last chapter we learned that perfectly competitive firms achieved
productive and allocative efficiency.
Productive efficiency refers to producing items at the lowest
possible cost.
Allocative efficiency refers to producing all goods up to the point
where the marginal benefit to consumers is just equal to the
marginal cost to firms.
Monopolistic competition results in neither productive nor allocative
efficiency.

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Efficiency of Perfectly Competitive Firms

Figure 13.6a

Comparing long-run equilibrium under perfect

competition and monopolistic competition

In panel (a), a perfectly competitive firm in long-run equilibrium

produces at QPC, where price equals marginal cost, and average
total cost is at a minimum.
The perfectly competitive firm is both allocatively efficient and
productively efficient.
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Inefficiency of Monopolistically Competitive Firms

Figure 13.6a&b Comparing long-run equilibrium under perfect

competition and monopolistic competition

Monopolistically competitive firms in panel (b) produce the quantity

where MC=MR. The marginal benefit to consumers is given by the
demand curve, so MCMB: not allocatively efficient.
And average cost is above its minimum point: not productively
efficient.
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Is Monopolistic Competition Bad for Consumers?

The lack of efficiency suggests that monopolistic competition is a bad
situation for consumers.
But consumers might benefit from the product differentiation.
Example: If you were buying a car, would you prefer one
a. Produced and sold at the lowest possible cost, but not well-suited
to your tastes and preferences; or
b. Produced and sold at a higher cost, but designed to attract you to
purchasing it?
Many consumers are willing to accept a higher price for a
differentiated product. So monopolistic competition is not necessarily
bad for consumers.
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Making Peter Thiel and Monopolistic

the
Connection
Peter Thiel is a billionaire entrepreneur:

Competition

a co-founder of PayPal, and an early

investor in LinkedIn, Zynga, and
Facebook.
Thiel recommends entrepreneurs focus
on the monopoly part of monopolistic
competition; there are economic profits
to be made in the short run if you can
own a market; according to Thiel, by:
Having brand, scale, or cost
advantages
Taking advantage of network effects
Having proprietary technology
Thiels latest project: investing in NJOY,
a firm making e-cigarettes.
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How Marketing Differentiates Products

13.5 LEARNING OBJECTIVE

Define marketing and explain how firms use marketing to differentiate their
products.

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Marketing and Product Differentiation

Making customers believe that your product is worthwhile and
different from those of other firms is not a trivial exercise. It typically
involves some degree of marketing.
Marketing: All the activities necessary for a firm to sell a product to a
consumer.
Once a firm manages to differentiate its product, it must continue to
do so, or risk heading toward the long-run outcome of zero economic
profit. The process of doing this is known as brand management.
Brand management: The actions of a firm intended to maintain the
differentiation of a product over time.

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Advertising
Advertising is a critical element of marketing for monopolistically
competitive firms.
By advertising effectively, firms can increase demand for their
products.
But they can also use advertising to differentiate their products:
effectively making the demand curve more inelastic.
This allows firms to charge a higher price and earn more short-run
profit.

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Defending a Brand Name

Marketing experts and psychologists agree: a critical aspect of
marketing is creating a brand name for your product.
A successful brand name can help to maintain product differentiation,
and delay the ability of other firms to compete away your profits.
But firms must always try to maintain the perception of their product
as better than others, making sure that, for example:
A highly-successful name like Coke, Xerox, or Band-Aid is uniquely
associated to that product, and not to generic products,
Other firms dont illegally use their brand name, and
Franchisees and others legally allowed to use their brand name
maintain the level of quality and service you expect.

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What Makes a Firm Successful?

13.6 LEARNING OBJECTIVE

Identify the key factors that determine a firms success.

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What Makes a Firm Successful?

A firms ability to differentiate its product and to produce it at a lower
average cost than competing firms creates value for its customers.
Some factors that affect a firms profitability are not directly under
the firms control. Certain factors will affect all the firms in a market.
The factors under a
firms controlthe
ability to differentiate
its product and the
ability to produce it
at lower cost
combine with the
factors beyond its
control to determine
the firms profitability.
Figure 13.7
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What makes a firm successful?

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Making Is Being the First Firm in the Market a Key to Success?

the
Connection
By being the first to sell a particular good, a firm
may gain a first-mover advantage, finding its name
closely associated with the good in the publics
mind.
Surprisingly, though, recent research has shown
that the first firm to enter a market often does not
have a long-lived advantage over later entrants.
The Reynolds International Pen Company was
replaced by Bic; Apples iPod was not the first
digital music player; and Hewlett-Packard, which
currently dominates the laser printer market was
preceded by its inventor, Xerox. The same can be
said for disposable diapers, and web browsers.
In the end, providing customers with good products
at a low price is probably the best way to ensure
success.
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Common Misconceptions to Avoid

Monopolistically competitive firms produce the quantity where MC =
MR, not the lowest possible average cost.
Use the marginal cost and marginal revenue curves to determine
quantity; then use the demand and average total cost curves to
determine price, cost, and profit or loss.
Although our model predicts zero economic profit in the long run, the
long run might be delayed indefinitely by innovative firms.

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