Microeconomics- Chapter 13

What is monopolistic competition?

A: A market structure with a large number of firms, each producing differentiated products, competing on quality, price, and marketing, with free entry and exit. Firms have some price-setting power but face downward-sloping demand.

How does monopolistic competition differ from perfect competition?

A: Unlike perfect competition, monopolistic competition has product differentiation and firms can charge prices above marginal cost, creating excess capacity and a markup.

How does monopolistic competition differ from a monopoly?

A: Monopolistic competition has many firms, free entry, and zero long-run economic profit, while a monopoly has one firm, high barriers to entry, and can maintain long-run profits.

Key characteristics of monopolistic competition?

A:

• Many firms, each with small market share

• Differentiated products (not perfect substitutes)

• Downward-sloping demand curves

• Free entry and exit

• Non-collusive behavior

What measures are used to determine market concentration?

A:

• Four-firm concentration ratio: % of industry revenue by top 4 firms

• Herfindahl-Hirschman Index (HHI): Sum of squared market shares of the largest 50 firms

HHI thresholds for competitiveness?

A:

• <1500: Competitive

• 1500–2500: Moderately concentrated

• >2500: Highly concentrated

Limitations of concentration measures?

A:

1. Market scope may not match reality

2. High turnover or easy entry can maintain competition despite high concentration

3. Industry classifications may not reflect true market boundaries

How does a firm in monopolistic competition decide short-run output and price?

A:

• Produce where MR = MC

• Price is set using the demand curve at that quantity

• Economic profit = (Price − ATC) × Quantity

Can firms incur losses in the short run?

A: Yes, firms can minimize losses by producing where MR = MC, even if P < ATC.

Example of short-run profit calculation:

A: P = $75, ATC = $25, Q = 125 → Economic profit = (75 − 25) × 125 = $6,250

What happens in the long run for monopolistic competition?

A:

• Economic profit attracts new firms → demand for existing products falls

• Economic losses cause firms to exit → demand rises for remaining firms

• Long-run outcome: Price = ATC → zero economic profit

Excess capacity & markup in monopolistic competition?

A:

• Excess capacity: Firms produce less than the efficient scale (Q < Q at minimum ATC)

• Markup: Price > MC

Is monopolistic competition efficient?

A: Partially:

• Allocative inefficiency: P > MC → underproduction

• Product variety: Consumers benefit from choice → can offset inefficiency

• Tradeoff: Variety vs. excess capacity & selling costs

Why do firms innovate in monopolistic competition?

A: To differentiate products, temporarily reduce demand elasticity, increase price, and earn economic profits.

When is product development efficient?

A: When marginal social benefit = marginal social cost of innovation.

Why do firms continuously innovate?

A: Imitators erode profits, prompting repeated innovation to maintain competitive advantage.

Why do firms advertise in monopolistic competition?

A:

• Signal product quality

• Increase demand

• Differentiate from competitors

How does advertising affect costs and demand?

A:

• Increases fixed costs → can raise ATC

• Increases demand elasticity → can increase quantity sold and lower markup

Example of advertising as a quality signal:**

• High-quality product (Coke) invests heavily in advertising → builds consumer trust and loyalty

• Low-quality product (Oke) cannot sustain heavy advertising → fails in the long run

Role of brand names:**

• Signal quality

• Encourage producers to maintain consistent standards

• Reduce consumer uncertainty in product selection

Are advertising and brand names efficient?

A: Ambiguous:

• Gains: Provide info, promote product variety

• Costs: Selling costs, excess capacity, cosmetic innovation

MR, MC, ATC in short-run monopolistic competition:**

• Profit-maximizing output: MR = MC

• Price set on demand curve at Q

• Profit = (P − ATC) × Q

Long-run monopolistic competition graph:**

• Demand shifts left as new firms enter

• Intersection of demand curve and ATC → zero economic profit

• Firm produces less than efficient scale → excess capacity

Comparison to perfect competition:**

• Perfect competition: P = MC, Q = efficient scale, zero markup

• Monopolistic competition: P > MC, Q < efficient scale, positive markup

Real-World Examples

• Monopolistic competition: Pizza, clothing, restaurants, gas stations, sporting goods

• Oligopoly: Airplanes

• Monopoly: Cable TV

• Perfect competition: Wheat, honey

What is the key tradeoff in monopolistic competition?

A: Product variety vs. economic efficiency (excess capacity and higher prices).

Why are advertising costs high in monopolistic competition?

A: Firms need to differentiate products and signal quality to consumers.

Why do firms use brand names?

A: To signal consistent quality, build reputation, and maintain customer loyalty.

What is the key difference between monopolistic competition and perfect competition regarding pricing?

A: In monopolistic competition, firms have some control over price due to product differentiation, while in perfect competition, firms are price takers and sell at market price.

What causes excess capacity in monopolistic competition?

A: Firms produce less than the efficient scale because they maximize profit where MR = MC, not where ATC is minimized, leaving unused capacity.

Why does monopolistic competition lead to a markup over marginal cost?

A: Because the demand curve is downward sloping for differentiated products, price > MC, creating a markup.

How does long-run equilibrium occur in monopolistic competition?

A: New firms enter when there is economic profit, shifting the demand curve left, until price = ATC, resulting in zero economic profit. Losses cause exit, shifting demand right.

Why are advertising costs so high in monopolistic competition?

A: To differentiate products, signal quality, and inform or persuade consumers; it can also increase demand and reduce average cost per unit if sales increase enough.

How do brand names serve as a quality signal?

A: They show consumers that firms maintain consistent, high-quality products because the firm has reputation to protect, encouraging repeat purchases.

How does monopolistic competition balance product variety vs efficiency?

A: Variety provides consumer benefit and choice (external benefit), but too many varieties increase costs. Efficiency occurs when marginal social benefit of variety = marginal social cost.

Why might advertising not always be efficient?

A: Because costs may exceed the consumer benefits of extra information, especially if advertising is just persuasive or cosmetic rather than informative.

How are concentration measures like the HHI or four-firm ratio limited?

A: They may not account for geographic scope, market boundaries, or firm turnover, so a high concentration ratio does not always mean low competition.

In the short run, how does a monopolistic competitor maximize profit or minimize loss?

A: By producing the quantity where MR = MC, and charging the price on the demand curve for that quantity.