54.Monopolistic competition

• Firms in monopolistic competition face competition from many other firms that produce a similar but differentiated product from its own.

• Firms in monopolistic competition maximize their profit by producing where MR = MC.

I. What Is Monopolistic Competition?

Monopolistic competition is a market structure in which:

• A large number of firms compete

• Each firm produces a differentiated product

• Firms compete on product quality, price, and marketing

• Firms are free to enter and exit

Large Number of Firms

• The large number of firms in a monopolistically competitive industry implies that each firm has a small market share, no firm can dictate market conditions, and collusion (conspiring to fix a higher price) is impossible.

Product Differentiation

• Product differentiation means that each firm makes a product that is slightly different from the products of competing firms. Some people will pay more for one variety of a product, so the demand curve for the firm’s product is downward sloping.

Competing on Quality, Price, and Marketing

• Product differentiation allows a firm to compete with other firms in product quality, price, and marketing.

Entry and Exit

• With no barriers to entry, firms in monopolistically competitive industries make zero economic profit in the long run.

Examples of Monopolistic Competition

• Examples of a monopolistic industry include audio and video equipment, sporting goods, and jewelry.

55) Price and Output in Monopolistic Competition

Short-Run Output and Price Decision

• The demand curve for a monopolistically competitive firm is downward sloping (similar to the demand curve for a monopoly). The downward sloping demand curve means that the firm’s marginal revenue curve also is downward sloping and lies below the demand curve.

• In the short run, a monopolistically competitive firm makes its output and price decisions just like a monopoly firm. The figure shows a monopolistically competitive firm’s downward sloping demand curve and the downward sloping MR curve, which, as noted, lies below the demand curve.

• The firm maximizes its profit by producing the quantity where MR = MC and using the demand curve to set the highest price at which people will buy the quantity it produces. In the figure, the firm produces 20 pizzas per hour and sets a price of $15 per pizza.

• The firm earns an economic profit if P > ATC (as is the case for the firm in the figure). If P = ATC, the firm earns zero economic profit, and if P < ATC, the firm incurs an economic loss.

• In the short run, profit maximizing quantity of output might be the loss minimizing quantity of output.

Long Run: Zero Economic Profit

• Unlike a monopoly, firms in monopolistic competition cannot earn economic profit in the long run. If the firms are earning an economic profit, other firms enter the market. Entry continues as long as firms in the industry earn an economic profit. As firms enter, each existing firm loses some of its market share. The demand for each firm’s product decreases and the firm’s demand curve shifts leftward.

• Eventually the demand decreases enough so that the firms earn only a normal profit, where P = ATC. Entry then stops. This outcome is illustrated in the figure, in which the firm produces 10 pizzas per hour (where MR = MC) and sets a price of $7.50 per pizza.

Monopolistic Competition and Perfect Competition

Unlike firms in perfect competition, firms in monopolistic competition have excess capacity and a markup:

• Excess Capacity: A firm has excess capacity if it produces less than its efficient scale, the quantity that minimizes its average total cost. In the long run, a firm in perfect competition produces at the minimum ATC but, a firm in monopolistic competition produces less than the quantity that minimizes the ATC.

• Markup: A firm’s markup is the amount by which its price exceeds its marginal cost. A firm in perfect competition has no markup but a firm in monopolistic competition charges a price that is greater than its marginal cost of production.

Is Monopolistic Competition Efficient?

Firms in monopolistic competition have higher costs than firms in perfect competition, but firms in monopolistic competition produce variety, which is valued by consumers. So compared to the alternative of complete uniformity