Monopolistic Competition

This Chapter

We have learned two opposite cases of market structures

• Perfect competition and monopoly

Today: monopolistic competition

• It combines the features of both monopoly and perfect competition

• Many markets in our daily life can be characterized as monopolistic competition

What Is Monopolistic Competition?

Monopolistic competition is a market structure in which

• Many firms compete.
• Each firm produces a differentiated product.
• Firms compete on product quality, price, and marketing.
• Firms are free to enter and exit the industry.
What Is Monopolistic Competition?

Large Number of Firms

Under monopolistic competition, the large number of firms in the market
implies that:
• Each firm has a small market share and so limited market power to influence the
price of its product.
• Each firm is sensitive to the average market price but pays no attention to the actions
of others, so no one firm’s actions directly affect the actions of others.
• Collusion or conspiring to fix prices is impossible.
What Is Monopolistic Competition?

Product Differentiation
A firm in monopolistic competition practices product differentiation if the
firm makes a product that is slightly different from the products of
competing firms.
What Is Monopolistic Competition?

Competing on Quality, Price, and Marketing

Product differentiation enables firms to compete in three areas: quality,
price, and marketing.
• Quality includes design, reliability, and service.
• Because firms produce differentiated products, the demand for each firm’s product
is downward sloping. But there is a tradeoff between price and quality.
• Because products are differentiated, a firm must market its product. Marketing takes
the two main forms: advertising and packaging.
What Is Monopolistic Competition?

Entry and Exit

There are no barriers to entry in monopolistic competition, so firms cannot
make an economic profit in the long run.

Examples of Monopolistic Competition

Producers of audio and video equipment, clothing, jewelry, computers, and
sporting goods operate in monopolistic competition.
What Is Monopolistic Competition?
Examples of monopolistic competition
Price and Output in
Monopolistic Competition
The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its marketing program
produces the profit-maximizing quantity (the quantity at which 𝑀𝑅 = 𝑀𝐶).
Price is determined from the demand for the firm’s product and the highest
price that the firm can charge for the profit-maximizing quantity.
Price and Output in
Monopolistic Competition
The firm in monopolistic competition
operates like a single-price monopoly.
The firm produces the quantity at
which 𝑀𝑅 equals 𝑀𝐶 and sells that
quantity for the highest possible price.
It makes an economic profit (as in this
example) when 𝑃 > 𝐴𝑇𝐶.
Price and Output in
Monopolistic Competition
Profit Maximizing Might Be Loss
Minimizing
A firm might incur an economic loss
in the short run.
In the figure, at the profit-
maximizing quantity, 𝑃 < 𝐴𝑇𝐶 and
the firm incurs an economic loss.
Price and Output in
Monopolistic Competition
Long Run: Zero Economic Profit
In the long run, economic profit induces entry…
and entry continues as long as firms in the industry make an economic
profit: 𝑃 > 𝐴𝑇𝐶.
In the long run, a firm in monopolistic competition maximizes its profit by
producing the quantity at 𝑀𝑅 = 𝑀𝐶.
Price and Output in
Monopolistic Competition
• As firms enter the industry, each existing
firm loses some of its market share.
• The demand for its product decreases.
• The decrease in demand decreases the
quantity at which 𝑀𝑅=𝑀𝐶 and lowers
the maximum price that the firm can
charge to sell this quantity.
• As new firms enter, the firm's price and
quantity fall until 𝑃=𝐴𝑇𝐶 and each firm
earns zero economic profit.
Price and Output in
Monopolistic Competition
Monopolistic Competition and Perfect Competition
Two key differences between monopolistic competition and perfect competition are
• Excess capacity
• Markup
A firm has excess capacity if it produces less than the quantity at which ATC is a
minimum.
A firm’s markup is the amount by which its price exceeds its marginal cost.
Price and Output in
Monopolistic Competition
In long-run equilibrium, firms in
monopolistic competition produce
less than the efficient scale—the
quantity at which ATC is a minimum.
They operate with excess capacity.
The downward-sloping demand
curve for their products drives this
result.
Price and Output in
Monopolistic Competition
Firms in monopolistic competition
operate with positive markup.
Again, the downward-sloping
demand curve for their products
drives this result.
Price and Output in
Monopolistic Competition
In contrast, firms in perfect
competition have no excess capacity
and no markup.
The perfectly elastic demand curve
for their products drives this result.
Price and Output in
Monopolistic Competition
Is Monopolistic Competition Efficient?
Price equals marginal social benefit.
The firm’s marginal cost equals marginal social cost.
Because price exceeds marginal cost, marginal social benefit exceeds
marginal social cost, so the firm in monopolistic competition produces less
than the efficient quantity in the long run.
Price and Output in
Monopolistic Competition
Making the Relevant Comparison
The markup (price minus marginal cost) arises from product differentiation.
People value product variety, but product variety is costly.
The efficient degree of product variety is the one for which the marginal
social benefit from product variety equals its marginal social cost.
The loss that arises excess capacity is offset by the gain that arises from
having a greater degree of product variety.
Product Development and Marketing

Product Development
We’ve looked at a firm’s profit-maximizing output decision in the short run
and in the long run, for a given product and with given marketing effort.
To keep making an economic profit, a firm in monopolistic competition must
be in a state of continuous product development.
New product development allows a firm to gain a competitive edge, if only
temporarily, before competitors imitate the innovation.
Product Development and Marketing

Innovation is costly, but it increases total revenue.

Firms pursue product development until the marginal revenue from
innovation equals the marginal cost of innovation.
The amount of production development is efficient if the marginal social
benefit from an innovation (which is the amount the consumer is willing to
pay for the innovation) equals the marginal social cost that firms incur to
make the innovation.
Product Development and Marketing

The Moore’s Law

The number of transistors in an integrated
circuit doubles about every 2 years
It is named after Gordon Moore, co-
founder of Fairchild Semiconductor and
former CEO of Intel, in 1965.
The semiconductor technology is a
general-purpose technology, which is
applied in…
• personal computers, cell phones, AI,
machine learning, …
Product Development and Marketing

Advertising
A firm with a differentiated product needs to ensure that customers know
that its product differs from its competitors.
Firms use advertising and packaging to achieve this goal.
A large proportion of the price we pay for a good covers the cost of selling it.
Advertising expenditures affect the firm’s profit in two ways: They increase
costs, and they change demand.
Product Development and Marketing

Selling Costs and Total Costs

Selling costs, such as advertising expenditures, fancy retail buildings, etc. are
fixed costs.
Average fixed costs decreases as output increases, so selling costs increase
average total cost at any given quantity but do not change marginal cost.

Selling Costs and Demand

Successful advertising increases the demand for the firm’s product.
But if all firms advertise and new firms enter, the demand for any firm’s
product will decrease.
Product Development and Marketing

For a pair of running shoes of $70:

• $9 (materials), $2.75 (labor cost of the
Malaysian worker), $5.25 (production
and transportation services), $3 (import
duty).
• The remaining $50 is selling costs:
advertising, retailing, and other sales
and distribution services.
• Advertising costs are often only a small
part of total selling costs (~$4).
• The biggest part of selling costs is the cost
of retailing services (~$46, including the
profit).
Product Development and Marketing

With no advertising, this firm

produces 25 units of output at an
average total cost of $60.
Advertising costs might lower the
average total cost by increasing the
quantity produced and spreading
their fixed costs over the larger
output.
Product Development and Marketing

With advertising, the firm can

produce 100 units of output at an
average total cost of $40.
Advertising expenditure shifts the
ATC curve upward, but …
the firm operates at a larger output
and lower average total cost than it
would without advertising.
Product Development and Marketing

Advertising (of all firms) might also

shrink the markup.
Figure (a) shows that with no
advertising, the demand for a firm’s
output is not very elastic and its
markup is large.
Product Development and Marketing

Figure (b) shows that if all firms

advertise, the demand for a firm’s
output becomes more elastic.
The firm produces a larger quantity,
its price falls, and its markup shrinks.
Product Development and Marketing

Using Advertising to Signal Quality

Why do Coke and Pepsi spend millions of dollars a month advertising
products that everyone knows?
One answer is that these firms use advertising to signal the high quality of
their products.
A signal is an action taken by an informed person or firm to send a message
to uninformed people.
Product Development and Marketing
Example of Signaling
Coke is a high quality cola, and Oke is a low quality cola.
• If Coke spends millions on advertising, people think “Coke must be good.”
• If it is truly good, when they try it, they will like it and keep buying it.
• If Oke spends millions on advertising, people will think “Oke must be good.”
• If it is truly bad, when they try it, they will hate it and stop buying it.

• So if Oke knows its product is bad, it will not bother to waste millions advertising it.
• And if Coke knows its product is good, it will spend millions advertising it.
• Consumers will read the signals and get the correct message.
• None of the ads need to mention the product. They just need to be flashy and expensive.
Product Development and Marketing

Brand Names
Why do firms spend millions of dollars to establish a brand name or image?
• Again, the answer is to provide information about quality and consistency.
• You’re more likely to enjoy hamburgers at Shake Shack than some street fast-food
because Shake Shack has incurred the cost of establishing a brand name and you
know what to expect if you eat there.

Efficiency of Advertising and Brand Names

To the extent that advertising and selling costs provide consumers with
information and services that they value more highly than their cost, these
activities are efficient.
Case: Product Differentiation in
Streaming Services
World-Wide Streaming Subscriptions Pass 1 Billion
While global box-office revenues plunged during the pandemic, ... the direct-to-consumer
streaming model became the dominant growth strategy.
The Wall Street Journal, March 18, 2021
The State of the Streaming Wars as We Head into 2021
Now that Netflix has a full slate of competitors, where does it stand compared with Disney Plus,
HBO Max, Amazon Prime Video, Apple TV Plus.
[Link], December 26, 2020
Amazon buying MGM for $8.45 Billion
The deal is designed to help Amazon supercharge its Amazon Prime.
[Link], May 26, 2021
Amazon Bets a Billion on NFL’s Thursday Night Football
Amazon will pay about $1 billion a year to be the exclusive carrier of Thursday Night football.
[Link], March 19, 2021
Case: Product Differentiation in
Streaming Services
• Video streaming services started when Youtube launched in 2005.
• Amazon prime started its streaming service in 2006, Netflix changed from being a DVD
rental service to video streaming in 2007, and Hulu launched in 2008.
• Over the next 12 years, more than 200 other firms have entered the video streaming
market, and a massive amount of content has become available.
Case: Product Differentiation in
Streaming Services
• We can understand the growth of offerings in the
market for video streaming services and amazon’s
decision to acquire MGM by using the monopolistic
competition model.
• The demand curve, D, and marginal revenue curve,
MR, slope downward because prime has a monopoly
on the items it offers.
• Amazon’s marginal cost low and constant, and it is also
the average variable cost.
• Most of amazon’s costs are fixed—they don’t change
when the number of subscribers changes.
• Amazon maximizes its economic profit by selling the
number of subscriptions at which 𝑀𝑅 = 𝑀𝐶. The EP is
positive.
• Seeing the opportunity for economic profit, other
streaming service providers innovate to create a yet
better lineup of content to take some of the market.
Case: Product Differentiation in
Streaming Services
• We can understand the growth of offerings in the
market for video streaming services and amazon’s
decision to acquire MGM by using the monopolistic
competition model.
• The demand decreases as the market is shared with the
other firms and Amazon’s profit-maximizing
subscription price falls and economic profit is
eliminated.
• to avoid this outcome, Amazon’s most recent move was
to buy MGM.
• Buying MGM increases prime’s total fixed cost, but it
also increases the demand for a prime subscription and
Amazon hopes it maintains a positive economic profit.