Monopolistic Competition

Monopolistic competition has characteristics of both competition and monopoly. Similar

to competition, it has many firms, and free exit and entry. Similar to monopoly, the
products are differentiated and each company faces a downward sloping demand curve.
Since the company has a differentiated product, it is like a monopolist and faces a
negatively-sloped demand curve. In the short-run,

• marginal revenue is always less than demand

• profit is maximized where MR = MC
• profit = (price - average total cost) x quantity

The short-run equilibrium in monopolitic competition is the same as for a monopolist,

and businesses may make positive, zero, or negative profits in the short run.

Long Run Equilibrium

In the long run, entry and exit are both possible. If profit is greater than zero, businesses
will enter, and each company's market share will fall because of more variety. As a result,
each company’s demand curve will decrease, along with price and quantity. If profit is
less than zero, businesses will exit, and each company’s market share will increase. This
will cause the remaining companies' demand curves to increase, along with the price and
quantity.

If profit is equal to zero, there will be no entry into or exit from the industry. In the long
run, all the companies' economic profits must be zero.

Monopolistic Competition and Welfare

Let's compare a company in monopolistic competition with a company in perfect
competition, where both are in a long-run equilibrium. In both cases, profit equals zero.
The two main differences between the two are:

1. Excess Capacity
o companies in perfect competition produce where ATC is at a minimum
(efficient scale)
o companies in monopolistic competition produce where quantity of output
is smaller, and on a downward sloping part of ATC (excess capacity)
o could increase capacity and lower average costs
2. Make-up Over Marginal Cost
o for a competitive firm, price = marginal cost
o for a monopolistic competition firm, price > marginal cost
o there is a mark-up above MC even though the firm makes zero profits
Efficient Outcomes and Externalities
When price is greater than marginal cost, the value that consumers place on the last unit
is greater than the cost, so the good is under-produced. This leads to a deadweight loss
like a monopolist. The number of businesses in the industry may be inefficient, and each
time a new business enters, it creates externalities such as,

• Product Variety Externality - consumers get a wider choice of products, and an

increase in consumer surplus which is a positive externality
• Business-Stealing Externality - this is a negative externality whereby other
businesses lose customers

Since companies do not take these into account, there are no guarantees that there is an
optimum number of them in the industry. This means that there may be too few or too
many products available on the market.

Product Differentiation through Advertising

Companies that wish to differentiate products often use advertising. Advertising is
common with differentiated consumer products, and much less common with
homogeneous goods. Forms of advertising include television, radio, direct mail,
billboards, etc. Advertising has a wide range of costs and benefits.

One cost of advertising, is that it may be mostly aimed at manipulating tastes of

consumers without conveying any useful information. Advertising may also try to create
differentiation within products that are actually very similar. Also, advertising tries to
make demand curves less elastic, and impedes competition. This then leads to a high
markup over marginal cost.

Some benefits to advertising, is that it does convey some useful information such as
prices, new products, locations, etc. Advertising may also foster competition by giving
more information on pricing and availability. Advertising may also be a “signal of
quality”, because willingness to spend money to advertise products may be a sign that the
company has confidence in its quality. This makes it rational for consumers to try such
products even if content of ads is minimal.

I. Monopolistic Competition

A. Characteristics

1. Firms have market power - the ability to raise price profitably above
MC.
 2. Firms make zero economic profits

3. Firms face downward sloping residual demand curves due to

differentiated products.

4. Downward sloping residual demand curve means firm has market

power.

B. Two types of models

1. Representative consumer model - all firms compete equally for all

consumers who typically buy from each firm (restaurants).

2. Spatial or location models - each customer prefers products that have

certain characteristics or are sold by firms located near them and is willing
to pay a premium for those preferred products.

II. Product Differentiation

A. Key Concepts

1. Products are different because consumers think they are different (i.e.
Tylenol vs. Osco Brand Ascenomenophen (SP?)

2. Pricing of one brand exerts a greater constraint on another brand's

pricing when the two brands are close substitutes than when they are not.

B. Two approaches to analyzing differentiation

1. Consumers have preferences regarding commodities.

2. Consumers have preferences regarding attributes or characteristics of

commodities (Lancaster 1966)
 Cereals = More sugar --------- Less Sugar

Captain Crunch Shredded Wheat

C. Demand Curve facing individual firm in monopolistic competition is

1. Downward sloping.

2. Dependent on prices of each rival product.

III. Representative Consumer Model

A. With undifferentiated products, its the same as the Cournot oligopoly

model but there is free entry.

Q(p) = 1000-1000P

C(q) = .28q+F

MC = .28 AC = .28 + F/q

Entry condition - firms enter if profit > 0

To find # of firms

1. Determine Cournot Output for each possible # of firms

2. Pick one in which firms make zero profit

 OR

Set P=AC and solve for N

Cournot with N firms F=6.40

# of firms Firm output Price Firm profit

720/(n+1) (.28n+1)/(n+1) 518.4/(n+1)^2-F
1 360 64 123.2
2 240 52 51.2
3 180 46 26
4 144 42.4 14.34
5 120 40 8
6 102.9 38.3 4.18
7 90 37 1.7
8 80 36 0
9 72 35.2 -1.22

To derive formulas, we get

n identical firms

q1(p)=Q(p)-(n-1)q2

profit1=(1-.001Q)q1-.28q-F

profit1=(1-.001(q1+(n-1)q2))q1-.28q1=q1-.001(q1)2-.001(n-1)q1q2-.28q1-
F
dprofit1/dq1=1-.002q1-.001(n-1)q2-.28=0

.72-.001(n-1)q2=.002q1

know that q1=q2 in equilibrium

.72=.002q1+.001(n-1)q1

.72=.001(q1)(n-1+2)

.72(1000)/(n+1)=q1

q1=720/(n+1)

industry output = Q=720n/(n+1)

To find price:

Q=1000-1000P

720n/(n+1)=1000-1000P

1000P=1000-720n/(n+1)

P=1-720n/1000(n+1)=(1000(n+1)-720n)/1000(n+1)=(.28n+1)/(n+1)

To find profit:

profit1=(1-.001Q)q1-.28q-F

profit1=(1-.001nq1)q1-.28q1-F=.72q1-.001nq12-F=.72(720/(n+1))-.
001n(720/(n+1))2-F=

518.4/(n+1)-518.4n/(n+1)2-F=518.4/(n+1)2-F

The other method is to find N directly by setting P=AC

 (.28n+1)/(n+1)=.28+6.40/(720/(n+1)), multiplying both sides by n+1

.28n+1=.28(n+1)+6.40/720(n+1)2, multiplying out we get

1-.28=.0089n2+.0178n+.0089, dividing by .0089 and moving to one side

we get

0=n2+2n-80=(n+10)(n-8)

n=8

According to Table 8.2 p. 293, if fixed costs are $1.60, 17 firms will be in
the industry. Thus, the lower the fixed costs, the higher the equilibrium
number of firms. Lower fixed costs lead to higher profits which lead more
firms to enter. (Fixed costs don't affect output decision of price.)

B. Representative Consumer Model with Differentiated Products

1. Same as before but a firm's residual demand curve depends on the

individual quantities produced by each of its competitors rather than on
just the total quantity.

Pi=a-biqi-b2qj(j/=I)

2. Results

A. price is above MC

B. product differentiation

1. Highly desirable products may not be produced even

though P>VC if fixed costs are so great that firms lose
money - too little variety.

2. Offsetting force - when firm introduces new brand it

ignores the effect of its increased competition on the profits
 of other firms = thus they tend to produce too many
products from social optimal.

IV. Location Models - consumers view each firm's product as having a particular location
in geographic or product (characteristic) space.

A. Hotelling's Location model (1929)

1. Long narrow city with only one street of a fixed length

2. Customers are uniformly distributed along this street and all customers
are identical except for location.

3. Each customer buys 1 quart of milk from nearest store

4. Two stores sell identical bottles of milk

|A|X|Y|B|

Store 1 I Store 2

For customer I, if x < y go to store 1

If y<x go to store 2

If x=y indifferent

Given that store 2 is located b miles from the end of town, where should
store 1 locate? (Just to the left of store 2) - analogy to product
characteristics and politics.

What if store 2 could costlessly relocate, where would it move? (To the
left of 1)

Where do both firms end up? (In the middle of town)

NOTE: Bertrand Model can have P> MC if there are heterogenous
products.