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287
stic Competition
WHAT’S NEW IN THE SEVENTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
what market structures lie between monopoly and competition.
competition among firms that sell differentiated products.
the desirability of outcomes in monopolistically competitive markets.
the debate over the effects of advertising.
CONTEXT AND PURPOSE:
Chapter 16 is the fourth chapter in a five-chapter sequence dealing with firm behavior and the
Chapter 13.
The purpose of Chapter 16 is to address
monopolistic competition
—a market structure in which many
firms sell products that are similar but not identical. Monopolistic competition differs from perfect
MONOPOLISTIC
COMPETITION
16
288 ❖ Chapter 16/Monopolistic Competition
KEY POINTS:
A monopolistically competitive market is characterized by three attributes: many firms, differentiated
products, and free entry.
Monopolistic competition does not have all of the desirable properties of perfect competition. There is
the standard deadweight loss of monopoly caused by the markup of price over marginal cost. In
addition, the number of firms (and thus the variety of products) can be too large or too small. In
practice, the ability of policymakers to correct these inefficiencies is limited.
CHAPTER OUTLINE:
I. Between Monopoly and Perfect Competition
by monopoly.
B. Firms in imperfect competition lie somewhere between the competitive model and the monopoly
model.
identical products.
1. Economists measure a market’s domination by a small number of firms with a statistic called
a
concentration ratio
.
2. The concentration ratio is the percentage of total output in the market supplied by the four
largest firms.
3. In the U.S. economy, most industries have a four-firm concentration ratio under 50%.
D. Definition of monopolistic competition: a market structure in which many firms sell
products that are similar but not identical.
1. Characteristics of Monopolistic Competition
a. Many Sellers
b. Product Differentiation
c. Free Entry
Chapter 16/Monopolistic Competition ❖ 289
E. Figure 1 summarizes the four types of market structure. Note that it is the number of firms and
the type of product sold that distinguishes one market structure from another.
Activity 1
—
Think of a Firm
Type: In-class assignment
Topics: Market structure
Materials needed: None
Time: 15 minutes
Class limitations: Works in any size class
Purpose
This assignment helps students relate the concept of market structure to the real world.
Instructions
Ask the class to answer the following questions. After they have answered all of them, ask the
students to share their answers with a neighbor. Ask the neighboring student to evaluate the
answer to the last question. List the four market structures on the board and ask for
examples that fit each category
1. Write the name of a specific firm. It should be a real company, not hypothetical.
2. What products or services does this firm sell? If the firm sells a wide variety of goods,
choose a single item to answer the following questions.
3. What other firms compete with this company? Are there many competitors, only a few,
or none?
4. Do the competing firms sell exactly the same product or does each company produce
goods with special characteristics?
5. Categorize the industry as one of the following market structures:
a. Perfect competition
— many firms
— one firm
— unique product
c. Oligopoly
— a few firms
— standard or differentiated product
d. Monopolistic competition
— many firms
— differentiated products
Figure 1
Draw a table with the four types of markets across the top. Create rows for various
market characteristics such as type of product sold, number of firms, control over
price, freedom of entry and exit, and ability to earn profit in the long run. Students
will then be able to see how these characteristics relate to one another.
290 ❖ Chapter 16/Monopolistic Competition
II. Competition with Differentiated Products
1. Each firm in monopolistic competition faces a downward-sloping demand curve because its
2. The monopolistically competitive firm follows a monopolist's rule for maximizing profit.
b. It sets the price using the demand curve to ensure that consumers will demand exactly
the amount produced.
Common Answers and Points for Discussion
Many students will choose companies that produce consumer goods, where product
differentiation is the most important characteristic. Most of these industries are either
oligopolies or monopolistically competitive. A few students may have examples of monopoly,
particularly utilities or patented medicines. Almost no one will give an example of perfect
competition.
Perfect competition, while an economic ideal, does not accurately describe all sectors of the
economy. Explaining that perfect competition is a special case (and adding some examples of
competitive industries) will help students understand why competitive firms face a horizontal
demand curve and have no control over the prices of their products.
Some students may have questions about the differences between oligopoly and monopolistic
competition. Differentiating between a “few” and “many” is not always easy. Measures of
market concentration can be used to explain the difference between these two imperfectly
competitive market structures.
Explain to students that product differentiation gives the seller in a monopolistically
competitive market some ability to control the price of its product. In a sense, each
firm is a monopoly in the production of its particular version of the product. This is
reflected by the fact that these firms face a downward-sloping demand curve. Point
out that the graph looks something like a monopoly, but that the demand the firm
faces will likely be much flatter (because it will be more elastic).
Chapter 16/Monopolistic Competition ❖ 291
3. We can determine whether or not the monopolistically competitive firm is earning a profit or
loss by comparing price and average total cost.
a. If
P
>
ATC
, the firm is earning a profit.
b. If
P
<
ATC
, the firm is earning a loss.
c. If
P
=
ATC
, the firm is earning zero economic profit.
B. The Long-Run Equilibrium
enter the market.
a. This increases the number of products from which consumers can choose.
b. Thus, the demand curve faced by each firm shifts to the left.
2. When firms in monopolistic competition are incurring losses, firms in the market will have an
incentive to exit.
a. Consumers will have fewer products from which to choose.
c. The losses of the remaining firms will fall.
3. The process of exit and entry continues until the firms in the market are earning zero profit.
Figure 2
292 ❖ Chapter 16/Monopolistic Competition
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
a. This means that the demand curve and the average-total-cost curve are tangent to each
other.
b. At this point, price is equal to average total cost and the firm is earning zero economic
profit.
4. There are two characteristics that describe the long-run equilibrium in a monopolistically
competitive market.
a. Price exceeds marginal cost (due to the fact that each firm faces a downward-sloping
demand curve).
b. Price equals average total cost (due to the freedom of entry and exit).
C. Monopolistic versus Perfect Competition
1. Excess Capacity
Figure 4
Point out to students that, just like firms in perfect competition, firms in monopolistic
competition also earn zero economic profit in the long run. Show them that this
result occurs because firms can freely enter the market when profits occur, driving
the level of profits to zero. Any market with no barriers to entry will see zero
economic profit in the long run.
Remember that students have a hard time understanding why a firm will continue to
operate if it is earning “only” zero economic profit. Remind them that zero economic
profit means that firms are earning an accounting profit equal to their implicit costs.
Figure 3
Chapter 16/Monopolistic Competition ❖ 293
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
a. The quantity of output produced by a monopolistically competitive firm is smaller than
the quantity that minimizes average total cost (the efficient scale).
b. This implies that firms in monopolistic competition have excess capacity, because the
firm could increase its output and lower its average total cost of production.
c. Because firms in perfect competition produce where price is equal to the minimum
2. Markup over Marginal Cost
a. In monopolistic competition, price is greater than marginal cost because the firm has
some market power.
D. Monopolistic Competition and the Welfare of Society
1. One source of inefficiency is the markup over marginal cost. This implies a deadweight loss
(similar to that caused by monopolies).
would be difficult.
3. Also, forcing these firms to set price equal to marginal cost would force them out of business
(because they are already earning zero economic profit).
4. There are also externalities associated with entry.
externality.
b. The
business-stealing externality
occurs because as new firms enter, other firms lose
c. Depending on which externality is larger, a monopolistically competitive market could
have too few or too many products.
5.
In the News: Insufficient Variety as a Market Failure
a. Firms may insufficiently service consumers with unusual preferences in markets with
large fixed costs
b. This article from
Slate
describes how some consumers get left out of the market because
of the high fixed costs associated with creating additional varieties of a product.
III. Advertising
A. The Debate over Advertising
1. The Critique of Advertising
294 ❖ Chapter 16/Monopolistic Competition
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
a. Firms advertise to manipulate people's tastes.
b. Advertising impedes competition because it increases the perception of product
differentiation and fosters brand loyalty. This means that consumers will be less
concerned with price differences among similar goods.
2. The Defense of Advertising
b. Advertising fosters competition because it allows consumers to be better informed about
all of the firms in the market.
a. In the United States during the 1960s, states differed on whether or not they allowed
advertising for optometrists.
difference of more than 20%).
B. Advertising as a Signal of Quality
1. The willingness of a firm to spend a large amount of money on advertising may be a signal to
2. Example: Kellogg and Post have each developed a new cereal that would sell for $3 per box.
(Assume that the marginal cost of producing the cereal is zero.) Each company knows that if
it spends $10 million on advertising, it will get one million new consumers to try the product.
If consumers like the product, they will buy it again.
advertise.
b. Kellogg knows that its cereal is great. Each person that buys it will likely buy one box per
month for the next year. Therefore, its sales would be $36 million, which is more than
enough to justify the advertisement.
quality of its cereal.
3. Note that the content of the advertisement is unimportant; what is important is that
consumers know that the advertisements are expensive.
C. Brand Names
