Lecture Notes Chapter 12: Monopolistic Competition

Instructional Objectives

After completing this chapter, students should be able to:

1. List the characteristics of monopolistic competition.

2. Explain how product differentiation occurs in similar products.

3. Determine the profit‑maximizing price and output level for a monopolistic competitor in the short run when given cost and demand data.

4. Explain why a monopolistic competitor will realize only normal profit in the long run.

5. Describe the four-firm concentration ratio as a way to measure market dominance in an industry.

6. Describe and compare the four-firm concentration ratio and the Herfindahl index as a way to measure market dominance in an industry.

7. Discuss why easy entry and exit into the industry is an important characteristic of a monopolistically competitive market.

8. Identify the reasons for excess capacity in monopolistic competition.

9. Explain how product differentiation may offset these inefficiencies.

10. Define and explain the terms and concepts listed at the end of the chapter.

Lecture Notes

Learning Objectives — After reading this chapter, students should be able to:

1. List the characteristics of monopolistic competition.

2. Explain why monopolistic competitors earn only a normal profit in the long run.

3. Explain why monopolistic competition delivers neither productive nor allocative efficiency.

4. Relate how the ability of monopolistic competition to deliver product differentiation helps to compensate for its failure to deliver economic efficiency.

Monopolistic Competition: Characteristics and Occurrence

1. Monopolistic competition refers to a market situation in which a relatively large number of sellers offer similar but not identical products.

   1. Each firm has a small percentage of the total market.

   2. Collusion is nearly impossible with so many firms.

   3. Firms act independently; the actions of one firm are ignored by the other firms in the industry

2. Product differentiation and other types of nonprice competition give the individual firm some degree of monopoly power that the purely competitive firm does not possess.

   1. Product differentiation may be physical (Qualitative).

   2. Services and conditions accompanying the sale of the product are important aspects of product differentiation.

   3. Location is another type of differentiation.

   4. Brand names and packaging lead to perceived differences.

   5. Product differentiation allows producers to have some control over the prices of their products.

3. Similar to pure competition, under monopolistic competition firms can enter and exit these industries relatively easily. Trade secrets or trademarks may provide firms some monopoly power.

4. Firms often heavily advertise their goods to communicate product differences, and nonprice competition is significant.

5. Monopolistically Competitive Industries

   1. Concentration ratios are one way to measure market dominance. The four-firm concentration ratio gives the percentage of total industry sales accounted for by the four largest firms. The concentration ratio has several shortcomings in terms of measuring competitiveness.

      1. Some markets are local rather than national, and a few firms may dominate within the regional market.

      2. If the four-firm concentration ratio is less than 40%, it’s likely to be monopolistically competitive.

   2. The Herfindahl index is another way to measure market dominance. It measures the sum of the squared market shares of each firm in the industry, so that a much larger weight is given to firms with high market shares.

Price and Output in Monopolistic Competition

1. The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition, because the seller’s product is differentiated from its rivals, so the firm has some control over price.

2. In the short-run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly.

3. In the long-run situation, the firm will tend to earn a normal profit only, that is, it will break even.

   1. Firms can enter the industry easily and will if the existing firms are making an economic profit. As firms enter the industry, this decreases the demand curve facing an individual firm as buyers shift some demand to new firms; the demand curve will shift until the firm just breaks even. If the demand shifts below the break-even point (Including a normal profit), some firms will leave the industry in the long run.

   2. If firms were making a loss in the short run, some firms will leave the industry. This will raise the demand curve facing each remaining firm, as there are fewer substitutes for buyers. As this happens, each firm will see its losses diminish until it reaches the break-even (Normal profit) level of output and price.

   3. Complicating factors are involved with this analysis.

      1. Some firms may achieve a measure of differentiation that is not easily duplicated by rivals (Brand names, location, etc.) and can realize economic profits even in the long run.

      2. There is some restriction to entry, such as financial barriers that exist for new small businesses, so economic profits may persist for existing firms.

      3. Despite complications, a normal profit in the long run is a reasonable reflection of the real world.

Monopolistic Competition and Economic Efficiency

1. Review the definitions of allocative and productive efficiency:

   1. Allocative efficiency occurs when price = marginal cost, i.e., when the right amount of resources are allocated to the product.

   2. Productive efficiency occurs when price = minimum average total cost, i.e., when production occurs using the least-cost combination of resources.

2. Neither productive nor allocative efficiency are achieved.

   1. P₃ is higher than the minimum ATC (A₄) at an output of Q₃, implying that productive efficiency is not achieved.

3. P₃ is greater than the MC at Q₃, failing to achieve allocative efficiency.

   1. Allocatively efficient output is at point c where demand intersects the MC.

   2. Producing output at Q₃ creates deadweight loss equivalent to acd.

4. Excess capacity will tend to be a feature of monopolistically competitive firms.

   1. If each firm could profitably produce at b (The minimum ATC), there would be a lower price.

   2. Fewer firms would be required to produce total output.

Product Variety

1. A monopolistically competitive producer may be able to postpone the long-run outcome of just normal profits through product development and improvement and advertising.

2. Compared with pure competition, this suggests possible advantages to the consumer.

   1. Developing or improving a product can provide the consumer with a diversity of choices.

   2. Product differentiation is at the heart of the tradeoff between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem.

   3. Average costs may also be higher than under pure competition, due to advertising and other costs involved in differentiation.

3. The monopolistically competitive firm juggles three factors — product attributes, product price, and advertising — in seeking maximum profit.

   1. This complex situation is not easily expressed in a simple economic model. Each possible combination of price, product, and advertising poses a different demand and cost situation for the firm.

   2. In practice, the optimal combination cannot be readily forecast but must be found by trial and error.

   3. “Consider This… The Spice of Life” discusses how market based economies promote product differentiation. This product differentiation is a benefit to society.

LAST WORD: Higher Wages, More McRestaurants

1. In the Monopolistically Competitive restaurant market, higher wages favor big chain restaurants over small “Mom and Pop” operations.

   1. The restaurant market is monopolistically competitive because each restaurant has a unique location and a differentiated product.

   2. Restaurants can differ on menu items, decor, prices, and a variety of other characteristics.

2. Restaurants also differ on their production methods.

   1. Large chain restaurants will employ specialized equipment in the production process. This includes specialized fryers and digital touch screens to process orders. Thus, the production process is capital intensive.

   2. Small “Mom and Pop” restaurants typically operate with the bare minimum in terms of cooking equipment. Thus, the production process is labor intensive.

3. In a monopolistically competitive market, equilibrium can often include both highly capitalized chain stores as well as lightly capitalized “Mom and Pop” stores.

4. Economists have discovered that wage increases can tilt the local restaurant market in favor of highly capitalized chain restaurants. This is because the higher wage does not affect the capital intensive chain restauraunts’ cost schedules. Thus, an increase in the minimum wage may cause more “Mom and Pop” restaurants to exit the market.