270
stic Competition
WHAT’S NEW IN THE EIGHTH 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.
➢ how the outcomes under monopolistic competition and under perfect competition compare.
➢ the desirability of outcomes in monopolistically competitive markets.
➢ the debate over the effects of advertising.
➢ the debate over the role of brand names.
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 based on the cost curves developed in
KEY POINTS:
• A monopolistically competitive market is characterized by three attributes: many firms, differentiated
products, and free entry and exit.
MONOPOLISTIC
COMPETITION
16
Chapter 16/Monopolistic Competition ❖ 271
• 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.
• The product differentiation inherent in monopolistic competition leads to the use of advertising and
brand names. Critics of advertising and brand names argue that firms use them to manipulate
consumers’ tastes and to reduce competition. Defenders of advertising and brand names argue that
firms use them to inform consumers and to compete more vigorously on price and product quality.
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
.
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
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.
Figure 1
272 ❖ Chapter 16/Monopolistic Competition
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
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.
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.
Chapter 16/Monopolistic Competition ❖ 273
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.
a. It chooses the output level where marginal revenue is equal to marginal cost.
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.
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).
274 ❖ Chapter 16/Monopolistic Competition
3. We can determine whether 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.
c. If
P
=
ATC
, the firm is earning zero economic 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.
b. Thus, the demand curve faced by each firm shifts to the left.
c. As the demand falls, these firms experience declining profit.
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.
a. This means that the demand curve and the average-total-cost curve are tangent to each
other.
Figure 2
Chapter 16/Monopolistic Competition ❖ 275
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 (because 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
a. The quantity of output produced by a monopolistically competitive firm is smaller than
the quantity that minimizes average total cost (the efficient scale).
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.
Figure 3
276 ❖ Chapter 16/Monopolistic Competition
c. Because firms in perfect competition produce where price is equal to the minimum
average total cost, firms in perfect competition produce at their efficient scale.
2. Markup over Marginal Cost
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).
2. Because there are so many firms in this type of market structure, regulating these firms
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.
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.
III. Advertising
A. The Debate over Advertising
1. The Critique of Advertising
a. Firms advertise to manipulate people’s tastes.
2. The Defense of Advertising
a. Firms use advertising to provide information to consumers.
b. Advertising fosters competition because it allows consumers to be better informed about
all of the firms in the market.
Chapter 16/Monopolistic Competition ❖ 277
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.
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 General Mills 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.
a. General Mills has discovered through market research that its new cereal is not very
good. After buying it once, consumers would not likely buy it again. Thus, it will only
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
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.
3. Economists have defended brand names as a useful way to ensure that goods are of high
quality.
Table 1
278 ❖ 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
Activity 2
—
Equilibrium Price for 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 jeans. After
they have drawn the graph, have them label the equilibrium price with a real dollar figure.
This dollar amount should reflect the price of jeans as accurately as possible.
Draw a standard supply and demand graph on the board. Ask a student for the equilibrium
price. Ask several more students for their prices.
Chapter 16/Monopolistic Competition ❖ 279
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
Chapter Quick Quiz
1. b
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
280 ❖ Chapter 16/Monopolistic Competition
Figure 2
3. Figure 3 shows the long-run equilibrium in a monopolistically competitive market. Price
equals average total cost. Price is above marginal cost.
4. Because, in equilibrium, price is above marginal cost, a monopolistic competitor produces too
little output. 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
it provides a signal of quality. A firm will not be willing to spend much money advertising a
Chapter 16/Monopolistic Competition ❖ 281
7. The two benefits that might arise from the existence of brand names are: (1) brand names
provide consumers information about quality when quality cannot be easily judged in
Problems and Applications
1. a. Tap water is a monopoly because there is a single seller of tap water to a household.
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
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.
282 ❖ Chapter 16/Monopolistic Competition
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.
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.
Chapter 16/Monopolistic Competition ❖ 283
c. The consumer surplus from the purchase of Sparkle toothpaste is areas A + B. The
b. The firm will produce where
MR
=
MC
:
8. Figure 5 shows the cost, marginal revenue and demand curves for the firm under both
conditions.
284 ❖ Chapter 16/Monopolistic Competition
9. a. A family-owned restaurant would be more likely to advertise than a family-owned farm
b. A manufacturer of cars is more likely to advertise than a manufacturer of forklifts
10. a. Figure 6 shows Sleek’s demand, marginal-revenue, marginal-cost, and average-total-cost
Chapter 16/Monopolistic Competition ❖ 285
Figure 6
b. In the long run, firms will enter, shifting the demand for Sleek’s product to the left. Its
price and output will fall. Firms will enter until profits are equal to zero (as shown in
Figure 7).
c. As consumers become more focused on the stylistic differences in brands, they will be
less focused on price. This will make the demand for each firm’s products more price