E1001_W8 - Monopolistic Competition Notes

Monopolistic Competition

Characteristics

• Many buyers and sellers: A large number of independent buyers and sellers participate in the market.
• Product differentiation:
  • Each firm sells a slightly differentiated product. This differentiation can be based on:
    • Differences in the good or service itself (e.g., quality, features).
    • Differences in location (e.g., convenience).
  • Due to product differentiation, each firm has some degree of market power, indicated by a downward-sloping demand curve.
  • However, this market power is limited by the availability of alternative products.
• Free entry and exit:
  • Firms can enter and exit the market freely in the long run, meaning there are no significant barriers to entry.
• Examples: Restaurants, convenience stores, laundromats are common examples of industries with monopolistic competition.

The Short Run (SR)

• Each firm in monopolistic competition sells a slightly differentiated product.
  • This gives the firm some control over the price it charges, resulting in a downward-sloping demand curve.
  • Consequently, a monopolistically competitive firm acts as a price maker.
  • The firm sets a profit-maximizing price and quantity in the same way a monopolist does.
  • In the short run, a firm can earn an economic profit or incur a loss.
  • The number of firms in the industry is fixed in the short run.

The Long Run

• There is free entry and exit in the long run, similar to perfect competition.

  • Firms enter the market if they anticipate positive profits.
  • Firms exit the market if they are sustaining losses.

• Impact of New Firm Entry:

  • Entry of a new firm affects the demand curves of existing (incumbent) firms.
    • Demand for incumbent firms' products decreases as the new firm offers an alternative, shifting the demand curve to the left.
    • The demand curve for each incumbent firm becomes more elastic because consumers have more substitutes to choose from, increasing their price sensitivity.

• Exit of firms has the opposite effect, increasing demand for remaining firms.

Elimination of Profits and Losses

• Free entry and exit eliminate economic profits and losses in the long run.
  • Entry decreases demand for existing firms, lowering prices and profits.
  • Exit increases demand for remaining firms, raising prices and profits.
• In the long run, firms remain price makers, facing a downward-sloping demand curve. They maximize profit by setting quantity $q_M$ where marginal revenue (MR) equals marginal cost (MC): $MR = MC$.
• Profits are zero when price (Pm) equals average total cost (ATC): $P_m = ATC$.
• For zero profits and price-making behavior to coexist, the ATC curve must be tangent to the demand curve at the profit-maximizing quantity ($q_m$). The ATC curve cannot intersect or lie entirely above the demand curve.

Welfare under Monopolistic Competition

• In the long run, firms operate where $P_m = ATC$.

• At this point, ATC > MC, indicating that average total cost (production costs) is not minimized. ATC is minimized when $ATC = MC$.

• Since P_m > MC, there is a deadweight loss (DWL) associated with each firm's output, representing unrealized gains from trade.

• Additional Welfare Factors:

  • Business stealing: A firm entering the market focuses on its own profits, potentially at the expense of existing firms' profits. This