Economics Chapter 15 Use The Three Conditions For Monopolistic Competition

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Chapter 15

Monopolistic Competition

and Product Differentiation

1. Use the three conditions for monopolistic competition discussed in the chapter to

decide which of the following firms are likely to be operating as monopolistic

competitors. If they are not monopolistically competitive firms, are they

monopolists, oligopolists, or perfectly competitive firms?

1. The three conditions for monopolistic competition are (1) a large number of

producers, (2) differentiated products, and (3) free entry and exit.

a. There are many bands that play at weddings, parties, and so on. There are no

significant barriers to entry or exit. And products are differentiated by quality

b. The industry for individual-serving juice boxes is dominated by a few very

large firms (for example, Minute Maid, Welch’s, and Kool Aid), and there are

c. There are a large number of dry cleaners, and each produces a product dif-

ferentiated by location: customers are likely to prefer to use the dry cleaner

d. There are a large number of soybean farmers, and there is free entry and exit

in this industry. However, soybeans are not differentiated from each other—

2. You are thinking of setting up a coffee shop. The market structure for coffee

shops is monopolistic competition. There are three Starbucks shops and two

Solution

S-232 Chapter 15 Monopolistic coMpetition and product differentiation

But you could further differentiate your product by style (for example, you

3. The market structure of the local gas station industry is monopolistic competi-

tion. Suppose that currently each gas station incurs a loss. Draw a diagram for a

3. Each gas station will produce the output, and so charge the price, that maxi-

mizes its profit or minimizes its loss. That is, it will produce quantity QU, where

marginal cost equals marginal revenue, and so charge price PU. Since the price

PU is lower than average total cost at the quantity QU, ATCU, each gas station

incurs a loss. That is, the situation for the typical gas station looks like the

accompanying diagram.

MRU

ATC

QUQuantity

Price,

cost,

mar

ginal

Since gas stations are incurring losses, in the long run some will exit the indus–

try. This shifts the demand and marginal revenue curves for each of the remain-

ing gas stations rightward. Exit continues until each remaining gas station

makes zero profit. This is the long-run equilibrium. The situation for the typi-

cal gas station in this equilibrium is illustrated in the accompanying diagram.

Demand has increased to the level at which this gas station makes zero profit at

a price of PMC and a quantity of QMC.

MRMC

DMC

ATC

QMC Quantity

MC = ATCMC

Price,

cost,

marginal

Solution

4. The local hairdresser industry has the market structure of monopolistic compe–

tition. Your hairdresser boasts that he is making a profit and that if he continues

to do so, he will be able to retire in five years. Use a diagram to illustrate your

hairdresser’s current situation. Do you expect this to last? In a separate diagram,

4. Your hairdresser currently makes a profit. His demand, marginal revenue, mar–

ginal cost, and average total cost curves are shown in the accompanying diagram.

MRP

Quantity

ATCP

Price,

cost,

mar

ginal

Since this hairdresser (and all other hairdressers) makes a profit equal to the

shaded rectangle by producing quantity QP at a price PP, there will be entry

into this industry. As more hairdressers open shops in town, demand for the

typical existing hairdresser will fall—the demand curve and marginal revenue

curve shift leftward. This will continue to the point at which no hairdresser

makes positive profit. This eliminates the incentive for further entry into the

industry, and long-run equilibrium is reached. The situation is illustrated in

the accompanying diagram.

QMC

MRMC

DMC

ATC

Quantity

MC = ATCMC

Price,

cost,

marginal

The best the typical hairdresser can do is to produce quantity QMC at a price of

PMC. Since price equals average total cost at this quantity, each hairdresser will

make exactly zero profit.

5. Magnificent Blooms is a florist in a monopolistically competitive industry. It is

a successful operation, producing the quantity that minimizes its average total

cost and making a profit. The owner also says that at its current level of output,

its marginal cost is above marginal revenue. Illustrate the current situation of

Magnificent Blooms in a diagram. Answer the following questions by illustrating

with a diagram.

a. In the short run, could Magnificent Blooms increase its profit?

b. In the long run, could Magnificent Blooms increase its profit?

Solution

5. The current situation of Magnificent Blooms is illustrated in the accompanying

diagram. It produces quantity Q1 at the minimum point of its average total cost

curve, and it charges price P1, making profit equal to the shaded rectangular area.

QPQ1

MRP

Quantity

ATC1

ATCP

Price,

cost,

mar

ginal

revenue

a. Yes, Magnificent Blooms could increase its profit in the short run by produc-

ing less. It would maximize its profit by producing quantity QP, the quantity

b. No. In the long run, Magnificent Blooms will make zero profit. The fact that

QMC

MRMC DMC

ATC

Quantity

Price,

cost,

marginal

revenue

MC = ATCMC

6. “In the long run, there is no difference between monopolistic competition and

perfect competition.” Discuss whether this statement is true, false, or ambiguous

with respect to the following criteria.

a. The price charged to consumers

Solution

6. a. According to this criterion, the statement is false. The price charged to con-

sumers is higher in monopolistic competition than it is in perfect competi-

b. According to this criterion, the statement is false. The average total cost of

production is higher for a monopolistically competitive firm than for a per-

fectly competitive firm. For a perfectly competitive firm in the long run, there

c. According to this criterion, the statement is ambiguous. The market outcome

under perfect competition is clearly efficient: price equals marginal cost, so

no firm wants to produce more output at a price at which consumers want

to buy more output. That is, no mutually beneficial trades between consum–

ers and producers go unexploited. The efficiency of monopolistic competition,

d. According to this criterion, the statement is true. Both perfectly competitive

firms and monopolistically competitive firms earn zero profits in the long run,

7. “In both the short run and in the long run, the typical firm in monopolistic com-

petition and a monopolist each make a profit.” Do you agree with this statement?

Explain your reasoning.

7. In the short run, a monopolist makes positive profit. Whether a firm in monopo–

listic competition makes a profit depends on how many firms there are in the

industry. If there are “too few” firms in the industry (relative to the long-run

equilibrium number of firms), then a typical firm in monopolistic competition

8. The market for clothes has the structure of monopolistic competition. What

impact will fewer firms in this industry have on you as a consumer? Address the

following issues.

Solution

S-236 Chapter 15 Monopolistic coMpetition and product differentiation

8. a. In monopolistic competition, firms seek to differentiate themselves by, among

other things, the type of clothes they sell. And to you, as a customer, there is

b. Monopolistically competitive firms also seek to differentiate themselves

through the quality of service they offer. There will be stores that take your

c. If there are fewer firms in this industry, each firm will sell a greater quantity

9. For each of the following situations, decide whether advertising is directly infor-

mative about the product or simply an indirect signal of its quality. Explain your

reasoning.

9. a. This commercial is not directly informative about the product since every

car manufacturer can claim that its car is better than any other; this is not a

statement that can be easily verified by the purchaser before purchase. How-

ever, Peyton Manning commands a very high fee for advertising. What the

10. In each of the following cases, explain how the advertisement functions as a

signal to a potential buyer. Explain what information the buyer lacks that is

being supplied by the advertisement and how the information supplied by the

Solution

10. a. The seller here is the job-seeker, who is selling his or her labor to a potential

employer. The potential employer lacks information on how good an employee

the job-seeker is—how dependable, diligent, and so on. By being willing to

b. The potential buyer lacks information on how good the merchandise is. By

11. The accompanying table shows the Herfindahl–Hirschman Index (HHI) for the

restaurant, cereal, movie studio, and laundry detergent industries as well as the

advertising expenditures of the top 10 firms in each industry. Use the informa-

tion in the table to answer the following questions.

Industry HHI Advertising expenditures (millions)

Restaurants 179 $1,784

a. Which market structure—oligopoly or monopolistic competition—best

characterizes each of the industries?

b. Based on your answer to part a, which type of market structure has higher

11. a. Recall from Chapter 14 that according to Justice Department guidelines, an

HHI below 1,500 indicates a strongly competitive market, an HHI between

1,500 and 2,500 indicates a somewhat competitive market, and an HHI over

2,500 indicates an oligopoly. So you should expect monopolistically competi-

tive industries to have an HHI below 1,500 and oligopolies to have an HHI

above 2,500. So the four industries are:

b. The market structure and advertising expenditures in each of the four indus-

tries correlate as follows:

Restaurants: monopolistic competition and high advertising expenditures

Cereal: oligopoly and medium advertising expenditures

Movie studios: monopolistic competition and high advertising expenditures

Laundry detergent: oligopoly and low advertising expenditures

Solution

12. McDonald’s spends millions of dollars each year on legal protection of its brand

12. The fast-food industry is a monopolistically competitive one, and companies

attempt to differentiate their product from that of other firms. McDonald’s

invests money in maintaining its brand name, which differentiates it from other

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13. The restaurant business in town is a monopolistically competitive industry

in long-run equilibrium. One restaurant owner asks for your advice. She

tells you that, each night, not all tables in her restaurant are full. She also

13. She should not lower her price. Since the industry is in long-run equilibrium,

each restaurant makes zero profit. That is, the restaurant’s demand, marginal

revenue, marginal cost, and average total cost curves are as shown in the

accompanying diagram.

MRMC

DMC

ATC

Price,

cost,

mar

ginal

revenue

Quantity

The restaurant owner produces output (the number of tables served) QMC at a

price of PMC

. The price is equal to average total cost, so she makes zero profit. If

she were to lower the price to P1, she would attract more customers and sell the

Solution