Monopolistic Competition

Characteristics:

• Relatively Large Numbers

• Firms have a small market share

• No collusion (concerted action by firms to restrict output and price)

• Firms act independently

• Product Differentiation

Economic rivalry takes the form of nonprice competition:

• product quality

• services and conditions surrounding the sale

• location (e.g. small grocery stores have higher prices and less products, but have more convenience than larger grocery stores)

• advertising and packaging

Easy entry and exit, but more difficult than in pure competition

Price and Output Determination

The firm's demand curve is highly, but not perfectly, elastic .

Why?

• There are fewer rivals than in pure competition

• Products are close, but not perfect substitutes

NOTE: The more producers, the less product differentiation, the more elastic the demand curve is

In the short run, monopolistically competitive firms will maximize it sprofits or minimizes its losses by producing at the point where MC = MR

In the long run, monopolistically competitive firms will earn only a normal profit, or, in other words, break even.

• If there are short run profits

1. More firms will enter the industry

2. The demand will fall because each firm has a smaller share of the total demand and because there are more close substitutes available

3. Demand curve becomes more elastic because there are more substitutes

4. When demand curve is tangent to ATC curve, the firm is breaking even

• If there are short run losses

1. Firms leave the industry

2. Faced with fewer substitutes, there is expanded demand

3. Losses go down, and give way to normal profit

Monopolistic Competition and Economic Inefficiency

• Monopolistically competitive firms produce at p, but the most efficient place to produce is at a.  Therefore,

• In monopolistic competition, excess capacity occurs and neither allocative nor productive efficiency is realized

Excess capacity -firms produce short of the most efficient output

• Monopolistically competitive markets also have slightly higher prices as well

Nonprice Competition in a Monopolistically Competitive Market

• Product Differentiation - consumers are offered a wide variety of products

• Product Development

Economics of Advertising

Traditional View of Advertising

•  Advertising is redundant and economically wasteful expenditure.  It is an inefficient use of scarce resources and causes higher costs and prices.

• Advertising is misleading and manipulates consumers

• Successful advertising leads to monopolies.

Effects on Demand Curve

-shifts it to the right

-becomes more inelastic

-this indicates a lessening of competition (charge higher prices with a less loss of sales)

New Perspective

• Advertising is an efficient means for both providing information to consumers and enhancing competition

• Consumers need information about products to make rational decisions.  Advertising is a low cost means of providing information

• Advertising enhances competition

Effects on Demand Curve

-shift it to the left

-becomes more elastic

-reflects enhanced competition

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