287
stic Competition
WHAT’S NEW IN THE SIXTH 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.
CONTEXT AND PURPOSE:
Chapter 16 is the fourth chapter in a five-chapter sequence dealing with firm behavior and the
organization of industry. The previous two chapters developed the two extreme forms of market
structure—competition and monopoly. The market structure that lies between competition and monopoly
is known as imperfect competition. There are two types of imperfect competition—monopolistic
competition and oligopoly. This chapter addresses monopolistic competition while the final chapter in the
sequence addresses oligopoly. The analysis in this chapter is again based on the cost curves developed in
Chapter 13.
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.
• The equilibrium in a monopolistically competitive market differs from that in a perfectly competitive
market in two related ways. First, each firm has excess capacity. That is, it operates on the
downward-sloping portion of the average-total-cost curve. Second, each firm charges a price above
marginal cost.
CHAPTER OUTLINE:
I. Between Monopoly and Perfect Competition
A. The typical firm has some market power, but its market power is not as great as that described
by monopoly.
C. Definition of oligopoly: a market structure in which only a few sellers offer similar or
identical products.
1. Economists measure a market’s domination by a small number of firms with a statistic called
a
concentration ratio
.
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
Figure 1
Chapter 16/Monopolistic Competition ❖ 289
b. Product Differentiation
c. Free Entry
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
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,
Draw a table with the four types of markets across the top. Create rows for various
Seinfeld, “The Café.”
(Season 3, 11:37-12:46; 19:06-20:01; 21:00-21:35.)
Jerry convinces Babu to serve Pakistani food—he’ll be the only Pakistani restaurant in
290 ❖ Chapter 16/Monopolistic Competition
II. Competition with Differentiated Products
A. The Monopolistically Competitive Firm in the Short Run
1. Each firm in monopolistic competition faces a downward-sloping demand curve because its
product is different from those offered by other firms.
2. The monopolistically competitive firm follows a monopolist’s rule for maximizing profit.
c. Oligopoly
— a few firms
— standard or differentiated product
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.
Figure 2
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
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. The Long-Run Equilibrium
1. When firms in monopolistic competition are making profit, new firms have an incentive to
enter the market.
a. This increases the number of products from which consumers can choose.
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.
3. The process of exit and entry continues until the firms in the market are earning zero profit.
Figure 3
292 ❖ Chapter 16/Monopolistic Competition
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.
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
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.
Chapter 16/Monopolistic Competition ❖ 293
a. The quantity of output produced by a monopolistically competitive firm is smaller than
the quantity that minimizes average total cost (the efficient scale).
2. Markup over Marginal Cost
a. In monopolistic competition, price is greater than marginal cost because the firm has
D. Monopolistic Competition and the Welfare of Society
2. Because there are so many firms in this type of market structure, regulating these firms
would be difficult.
4. There are also externalities associated with entry.
a. The
product-variety externality
occurs because as new firms enter, consumers get some
consumer surplus from the introduction of a new product. Note that this is a positive
externality.
5.
In the News: Insufficient Variety as a Market Failure
a. Economist Joel Waldfogel argues that firms may insufficiently service consumers with
unusual preferences.
III. Advertising
A. The Debate over Advertising
1. The Critique of Advertising
294 ❖ Chapter 16/Monopolistic Competition
2. The Defense of Advertising
3.
Case Study: Advertising and the Price of Eyeglasses
a. In the United States during the 1960s, states differed on whether or not they allowed
advertising for optometrists.
4.
FYI: Galbraith versus Hayek
a. In
The Affluent Society
(published in 1958), John Kenneth Galbraith argued that
corporations use advertising to create demand for products that people otherwise do not
want or need.
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
consumers about the quality of the product being offered.
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.
Chapter 16/Monopolistic Competition ❖ 295
C. Brand Names
1. In many markets there are two types of firms; some firms sell products with widely
recognized brand names while others sell generic substitutes.
2. Critics of brand names argue that they cause consumers to perceive differences that do not
really exist.
Activity 2
—
Equilibrium Price for Blue Jeans
Type: In-class demonstration
Topics: Product differentiation
Materials needed: None
Time: 5 minutes
Class limitations: Works in any size class
Purpose
This assignment shows that market supply and demand graphs give an oversimplified picture
of price when products are diversified.
Instructions
Ask the students to draw a supply and demand graph illustrating the market for blue jeans.
price. Ask several more students for their prices.
Common Answers and Points for Discussion
The class will have a whole range of prices for blue jeans, reflecting the range of blue jeans in
the real world. Recent prices at one shopping mall varied from $14 to more than $100 for a
Table 1
296 ❖ Chapter 16/Monopolistic Competition
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Oligopoly is a market structure in which only a few sellers offer similar or identical products.
Examples include the market for breakfast cereals and the world market for crude oil.
2. The three key attributes of monopolistic competition are: (1) there are many sellers; (2) each
firm produces a slightly different product; and (3) firms can enter or exit the market freely.
3. Advertising may make markets less competitive if it manipulates people’s tastes rather than
being informative. Advertising may give consumers the perception that there is a greater
difference between two products than really exists. That makes the demand curve for a
product more inelastic, so the firms can then charge greater markups over marginal cost.
However, some advertising could make markets more competitive because it sometimes
Chapter 16/Monopolistic Competition ❖ 297
Questions for Review
1. The three attributes of monopolistic competition are: (1) there are many sellers; (2) each
seller produces a slightly different product; and (3) firms can enter or exit the market without
2. In Figure 2, a firm has demand curve
D
1 and marginal-revenue curve
MR
1. The firm is
making profits because at quantity
Q
1, price (
P
1) is above average total cost (
ATC
). Those
profits induce other firms to enter the industry, causing the demand curve to shift to
D
2 and
the marginal-revenue curve to shift to
MR
2. The result is a decline in quantity to
Q
2, at which
point the price (
P
2) equals average total cost (
ATC
), so profits are now zero.
3. Figure 3 shows the long-run equilibrium in a monopolistically competitive market. Price
equals average total cost. Price is above marginal cost.
298 ❖ Chapter 16/Monopolistic Competition
4. Because, in equilibrium, price is above marginal cost, a monopolistic competitor produces too
little output. But this is a hard problem to solve because: (1) the administrative burden of
5. Advertising might reduce economic well-being because it manipulates people’s tastes and
6. Advertising with no apparent informational content might convey information to consumers if
7. The two benefits that might arise from the existence of brand names are: (1) brand names
Problems and Applications
1. a. Tap water is a perfectly competitive market because there are many taps and the
product does not differ across sellers.
b. Bottled water is a monopolistically competitive market. There are many sellers of bottled
water, but each firm tries to differentiate its own brand from the rest.
2. a. The market for wooden #2 pencils is perfectly competitive because pencils by any
manufacturer are identical and there are a large number of manufacturers.
b. The market for copper is perfectly competitive, because all copper is identical and there
are a large number of producers.
Chapter 16/Monopolistic Competition ❖ 299
3. a. A firm in monopolistic competition sells a differentiated product from its competitors.
b. A firm in monopolistic competition has marginal revenue less than price.
4. a. Both a firm in monopolistic competition and a monopoly firm face a downward-sloping
demand curve.
b. Both a firm in monopolistic competition and a monopoly firm have marginal revenue that
is less than price.
5. a. The firm is not maximizing profit. For a firm in monopolistic competition, price is greater
than marginal revenue. If price is below marginal cost, marginal revenue must be less
than marginal cost. Thus, the firm should reduce its output to increase its profit.
300 ❖ Chapter 16/Monopolistic Competition
6. a. Figure 4 illustrates the market for Sparkle toothpaste in long-run equilibrium. The profit-
maximizing level of output is
Q
M and the price is
P
M.
b. Sparkle’s profit is zero, because at quantity
Q
M, price equals average total cost.
c. The consumer surplus from the purchase of Sparkle toothpaste is areas A + B. The
efficient level of output occurs where the demand curve intersects the marginal–cost
7. a. As
N
rises, the demand for each firm’s product falls. As a result, each firm’s demand
curve will shift in.
b. The firm will produce where
MR
=
MC
:
100/
N
– 2
Q
= 2
Q
Q
= 25/
N
Chapter 16/Monopolistic Competition ❖ 301
8. Figure 5 shows the cost, marginal revenue and demand curves for the firm under both
conditions.
a. The price will fall from
PMC
to the minimum average total cost (
PC
) when the market
becomes perfectly competitive.
b. The quantity produced by a typical firm will rise to
QC
, which is at the efficient scale of
output.
9. a. A family-owned restaurant would be more likely to advertise than a family-owned farm
because the output of the farm is sold in a perfectly competitive market, in which there is
no reason to advertise, while the output of the restaurant is sold in a monopolistically
competitive market.
302 ❖ Chapter 16/Monopolistic Competition
cars. The possible return to advertising is greater in the case of cars than in the case of
forklifts.
10. a. Figure 6 shows Sleek’s demand, marginal-revenue, marginal-cost, and average-total-cost
curves. The firm will maximize profit at an output level of
Q
* and a price of
P
*. The
shaded are shows the firm’s profits.
Figure 6
Figure 7
Chapter 16/Monopolistic Competition ❖ 303
11. a. Perdue created a brand name for chicken by advertising. By doing so, he was able to
differentiate his product from other chicken, gaining market power.
12. a. Figure 8 shows Tylenol’s demand, marginal revenue, and marginal cost curves. Tylenol’s
price is
P
T, its marginal cost is
MC
T, and its markup over marginal cost is
P
T −
MC
T.
Figure 8