A Lecture Presentation

in PowerPoint
to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
Thomson Learning™ is a trademark used herein under license.

ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L.
Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic
network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work
covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or
mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or
information storage and retrieval systems—without the written permission of the publisher.
Printed in the United States of America
ISBN 0030342333

Copyright © 2002 by Thomson Learning, Inc.

 Chapter 11
Monopolistic Competition

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Many goods and services are traded in
circumstances that contain elements of
both monopoly and competition.
 Theories of monopolistic competition
and oligopoly deal with markets that lie
between the extreme cases of perfect
competition and monopoly.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Monopolistic competition is a market
structure where many producers of
somewhat different products compete
with one another.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Monopolistic competition has features in
common with both monopoly and
perfect competition.
 Like monopoly, individual sellers believe
that they have some market power.
 Unlike monopoly, there are many close
substitutes coming from other
monopolistically competitive firms.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Firms in monopolistically competitive
markets recognize the existence of
competitors.
 They impose a limit on the prices they
can charge and still sell a particular
level of output.
 But they do not consider competitors as
rivals who are watching them closely.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Monopolistic competition is similar to
perfect competition.
 the relatively free entry of new firms
 the long-run price and output behavior
 zero long-run economic profits
 However, the monopolistically
competitive firm produces a
differentiated product, which leads to
some degree of monopoly power.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 In a sense, each seller in a market of
monopolistic competition may be
regarded as a “monopolist” of its own
particular brand of the commodity
 Unlike a firm in the monopoly model,
there is competition by many firms
selling similar (but not identical) brands.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 The theory of monopolistic competition
is based on three characteristics:
 product differentiation,
 many sellers, and
 free entry.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Product differentiation is the
accentuation of unique product
qualities, real or perceived, to develop a
specific product identity.
 With differentiation, buyers believe that
the products of the various sellers are
not the same, whether the products are
actually physically different or not.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Product differentiation leads to
preferences among buyers to deal with
particular sellers or to purchase the
products of particular sellers.
 Sources of differentiation
 physical differences
 prestige considerations
 location
 service considerations

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 When many firms compete for the same
customers, any particular firm has little
control over or interest in what other
firms do.

Copyright © 2002 by Thomson Learning, Inc.

 11.1 Monopolistic Competition
 Entry in monopolistic competition is
relatively unrestricted:
 New firms may easily start the production
of close substitutes for existing products.
 Economic profits tend to be eliminated in
the long run, as is the case in perfect
competition.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 Monopolistically competitive sellers are
price searchers; they do not regard
price as a given by market conditions.
 Because each firm sells a slightly
different product, each firm’s demand
curve is downward sloping, but quite flat
(elastic) because of many close
substitutes.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 In perfect competition, each firm’s
demand curve was horizontal because
each firm, one of a great many sellers,
sold the same homogenous product.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 Given the position of an individual firm’s
demand curve, we can determine
short-run equilibrium output and price
using a method similar to that used to
determine monopoly output and price.
 The intersection of MR and MC curves
indicates the short-run equilibrium
output under monopolistic competition.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 By observing the price on the demand
curve at which that output can be sold,
we then find the short-run equilibrium
price.

Copyright © 2002 by Thomson Learning, Inc.

 Short-Run Equilibrium in Monopolistic
Competition

MC MC
ATC
ATC
A A
P* C
B B

Price
Price

C Total D P*
Total
Profits D
Losses
MR
MR

0 0
q* q*
(Profit Maximizing Output) (Loss Minimizing Output)
Quantity Quantity

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 The three-step method for monopolistic
competition is the same as for
monopoly . . .

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 Find q* where MR= MC.
 Go up to the demand curve then to the
left to find the market price.
 Go up from the profit-maximizing
quantity to ATC.
 If TR > TC (P is greater than ATC), the firm
is generating profits;
 if TR < TC (P is less than ATC), the firm is
generating losses.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 The short-run equilibrium situation,
whether involving profits or losses, will
probably not last long because there is
entry and exit in the long run.
 If market entry and exit are sufficiently
free,
 new firms will enter when there are
economic profits, and
 some firms will exit when there are
economic losses.
Copyright © 2002 by Thomson Learning, Inc.
 11.2 Price and Output Determination in
Monopolistic Competition
 If existing firms are earning economic
profits,
 new firms enter to take advantage of the
economic profits;
 the demand curves for each of the existing
firms will fall and become more elastic due
to increasing substitutes.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 This decline in demand continues until
ATC becomes tangent with the demand
curve, and economic profits are reduced
to zero.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 When monopolistically competitive firms
are making economic losses,
 some firms will exit the industry;
 the demand curves for the remaining firms
shift to the right and makes them more
inelastic due to reduced substitutes.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 The higher demand results in smaller
losses for the existing firms until the
losses disappear where the ATC curve
is tangent to the demand curve.

Copyright © 2002 by Thomson Learning, Inc.

 Market Entry and Exit in the Long Run
Price

MC MC ATC
ATC PLR = ATC
PLR = ATC
DLONG RUN
DSHORT RUN
DSHORT RUN
MR DLONG RUN MR
0 q* 0 q*
Quantity Quantity

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 Long-run equilibrium will occur when
demand is equal to average total cost
for each firm at a level of output at
which each firms’ demand curve is just
tangent to its ATC curve.

Copyright © 2002 by Thomson Learning, Inc.

 11.2 Price and Output Determination in
Monopolistic Competition
 The point of tangency will always occur
at the same level of output as where
MR = MC.
 At this equilibrium point, there are
 zero economic profits and
 no incentives for firms to either enter or exit
the industry.

Copyright © 2002 by Thomson Learning, Inc.

Long-Run Equilibrium for a Monopolistically
Competitive Firm

MC ATC
Price

PLR = ATC
DLONG RUN

MR
0
q*
Quantity

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 Both monopolistic competition and
perfect competition
 have many buyers and sellers
 and relatively free entry.
 However, product differentiation allows
a monopolistic competitor the ability to
have some influence over price.

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 A monopolistic competitive firm
 has a downward-sloping demand curve,
 but it tends to be more elastic than the
demand curve for a monopolist
 because of the large number of good
substitutes for its product.

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 Because of the downward slope of the
demand curve, its point of tangency with
ATC will not and cannot be at the lowest
level of average cost.
 Therefore, even when long-run
adjustments are complete, firms will not
be operating at a level that permits the
lowest average cost of productionthe
efficient scale of the firm.

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 The existing plant, even though optimal
for the equilibrium volume of output, will
not be used to capacity.
 That is, excess capacity will exist at that
level of output.

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 Unlike a perfectly competitive firm, a
monopolistically competitive firm could
increase output and lower its average
total costs.
 However, increasing output to attain
lower average costs would be
unprofitable. The price reduction
necessary to sell the greater output
would cause MR to fall below MC of the
increased output.
Copyright © 2002 by Thomson Learning, Inc.
 11.3 Monopolistic Competition
Versus Perfect Competition
 Consequently, in monopolistic
competition, there is a tendency toward
too many firms in the industry, each
producing a volume of output less than
that which would allow lowest cost.
 Economists call this failing to reach
productive efficiency—output production
is not minimizing average total costs.

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 In monopolistic competition, firms are
not operating where P = MC.
 At the intersection of MC and MR, P > MC.
 This means that society is willing to pay
more for the product (the price) than it
costs society to produce it.
 The firm is not allocativally efficient,
(where P = MC).
 Too many firms are producing at output
levels that are less than full capacity.
Copyright © 2002 by Thomson Learning, Inc.
 11.3 Monopolistic Competition
Versus Perfect Competition
 Perfectly competitive firms reach both
 productive efficiency (P = ATC at the
minimum point on the ATC curve)
 and allocative efficiency (P = MC).
 However, these drawbacks in the
monopolistically competitive market
would be far greater in monopoly, where
the demand curve is more inelastic
(steeper).

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 In monopolistic competition, the higher
average costs and the slightly higher
price and lower output may just be the
price we pay for differentiated
productsvariety.
 Just because we have not met the
conditions of productive and allocative
efficiencies, it is difficult to say whether
or not society is better off.

Copyright © 2002 by Thomson Learning, Inc.

 Comparing Long-Run Perfect Competition
and Monopolistic Competition

Price Price
Minimum point
Minimum of ATC MC
ATC
point of ATC MC
ATC
P = MC P = MR
P* (Demand
MC curve)
DLONG RUN
MR
Excess capacity
0 q* Efficient 0 Efficient
q* =
Scale

Quantity Quantity

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 Perfect competition meets the test of
allocative and productive efficiency and
monopolistic competition does not.

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 The significance of the difference
between the relationship of long-run
marginal cost to price in monopolistic
competition and in perfect competition
can easily be exaggerated.
 As long as preferences for various
brands are not extremely strong, the
demand for the products of firms will be
highly elastic.

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 Accordingly, the points of tangency with
the ATC curves are not likely to be far
above the point of lowest cost, and
excess capacity will be small.
 Only if differentiation is very strong will
the difference between the long-run
price level and that which would prevail
under perfectly competitive conditions
be significant.

Copyright © 2002 by Thomson Learning, Inc.

 The Impact of Product Differentiation

Minimum point Minimum point

Price

Price
of ATC of ATC

ATC ATC
Excess D
capacity
Excess D
capacity
0 0
q* Efficient Scale q* Efficient
Scale
Quantity Quantity

Copyright © 2002 by Thomson Learning, Inc.

 11.3 Monopolistic Competition
Versus Perfect Competition
 Remember: The theory of the firm is like
a road map that does not provide every
possible detail, but gives us directions
to get from one point to another.
 Any particular theory of the firm may not
tell us precisely how an individual firm
will operate, but rather will give us
valuable insight into the tendencies of
how firms will react to changing
economic conditions.
Copyright © 2002 by Thomson Learning, Inc.
 11.4 Advertising
 Advertising is an important non-price
method of competition that is commonly
used in monopolistic competition.
 By advertising, firms hope to increase
the demand and create a less elastic
demand curve for their products, thus
enhancing revenues and profits.

Copyright © 2002 by Thomson Learning, Inc.

 11.4 Advertising
 A successful advertising campaign can
increase demand and decrease its
elasticity by convincing buyers that a
firm’s product is truly different.
 The result would be greater profits.
 The degree to which advertising
impacts demand varies from market to
market.

Copyright © 2002 by Thomson Learning, Inc.

 The Impact of a Successful Advertising
Campaign

Price

DAFTER ADVERTISING
DBEFORE ADVERTISING
0
Quantity
Copyright © 2002 by Thomson Learning, Inc.
 11.4 Advertising
 Some have argued that advertising
 manipulates consumer tastes and wastes
billions of dollars annually creating “needs”
for trivial products,
 is sometimes based on misleading claims,
and/or
 in itself, advertising requires resources,
which raises average costs.

Copyright © 2002 by Thomson Learning, Inc.

 11.4 Advertising
 On the other hand, if one believes that
people are rational and should be
permitted freedom of expression, the
argument against advertising loses
some of its force.

Copyright © 2002 by Thomson Learning, Inc.

 11.4 Advertising
 While it is true that advertising can raise
average total costs, it is possible that in
situations where substantial economies
of scale exist, average production costs
may decline more than the amount of
per-unit costs of advertising, by allowing
firms to operate closer to the point of
minimum cost on their ATC curve.

Copyright © 2002 by Thomson Learning, Inc.

 11.4 Advertising
 If the increase in demand resulting from
advertising is significant, economies of
scale from higher output levels may
offset the advertising costs, allowing the
firm to sell at a lower price.
 Toys R Us is an example.

Copyright © 2002 by Thomson Learning, Inc.

 Advertising and Economies of Scale
Average Total Costs

C2 C
Increase in cost due
to advertising
C0 A
B
C1 ATCAFTER ADVERTISING

ATCBEFORE ADVERTISING

0 q0 q1
Quantity
Copyright © 2002 by Thomson Learning, Inc.
 11.4 Advertising
 Firms in monopolistic competition are
not likely to experience substantial cost
reductions as output increases.
 Therefore, they probably will not be able
to offset advertising costs with lower
production costs.

Copyright © 2002 by Thomson Learning, Inc.

 11.4 Advertising
 Even if advertising does add to total
cost, it does convey information.
 Customers become aware of options in
terms of product choice.
 It informs price-conscious customers about
the cost of the product.

Copyright © 2002 by Thomson Learning, Inc.

 11.4 Advertising
 Advertising reduces information costs,
so customers know about more
substitutes.
 Consequently, this leads to increasingly
competitive markets.
 Studies in the eyeglass, toy, and drug
industries have shown that advertising has
increased competition and led to lower
prices in these markets.

Copyright © 2002 by Thomson Learning, Inc.