Chapter 17: Monopolistic Competition

Monopolistic competition

A market structure in which many firms sell products that are similar but not identical.

Characteristics of monopolistic competition

Many sellers, product differentiation, free entry

Each firm in monopolistic competition faces a downward-sloping demand curve because

its product is different from those offered by other firms.

Output level is where

MC = MR.

If P > ATC in a monopolistically competitive firm,

the firm is earning a profit.

If P < ATC in a monopolistically competitive firm,

the firm is earning a loss.

If P = ATC in a monopolistically competitive firm,

the firm is earning zero economic profit.

When firms in in a monopolistic competition make profit,

new firms have an incentive to enter the market, increasing the number of products consumers can choose and shifting all demand curves left, leading to declining profit.

When firms in a monopolistic competition incur loss,

firms in the market will have an incentive to exit, limiting the products consumers can choose, shifting all demand curves right and make losses fall.

The process of exit and entry continues until

firms earn zero profit, meaning D and ATC are tangent to each other.

Characteristics that describe the long-run equilibrium in a monopolistically competitive market

P > MC (due to downward demand curves) && P = ATC (due to free entry and exit)

Excess capacity

The difference between a firm's profit-maximizing quantity and the quantity that minimizes average cost

Quantity of output produced by a monopolistically competitive firm is

SMALLER than the Q that minimizes ATC (efficient scale).

Forcing firms to set P = MC would

force them out of the market because they are already earning zero economic profit.

Product-variety externality

Consumers get extra surplus from the introduction of new products; positive.

Depending on which externality is larger,

a monopolistically competitive market can have too few/too many products.