Download Chapter 16 – Monopolistic Competition and Product Differentiation

Goldwasser
AP Microeconomics
Chapter 16 –
Monopolistic Competition and Product Differentiation
BEFORE YOU READ THE CHAPTER
Summary
This chapter develops the model of monopolistic competition. It also discusses
product differentiation and why oligopolistic and monopolistically competitive
firms engage in product differentiation. The chapter discusses the determination of
prices and profits in monopolistic competition in both the short run and the long
run. The chapter explores why monopolistic competition generates diversity of
products and the cost of this diversity. The chapter also considers the costs and
benefits from advertising and the creation of brand names.
Chapter Objectives
Objective #1. A monopolistically competitive industry is composed of many
competing firms selling differentiated products with free entry and exit of firms in
the long run. The three essential characteristics of monopolistic competition are a
large number of producers, differentiated products, and free entry and exit of firms
in the long run. Analysis of this market structure reveals that in some ways it
resembles perfect competition and in other ways it resembles monopoly.
Objective #2. Because monopolistically competitive firms sell differentiated
products, each firm has some degree of market power and therefore faces a
downward-sloping demand curve for its product. In fact, product differentiation is
the only way monopolistically competitive firms acquire market power. This
implies that these firms, like a monopoly, have some power to set the price they
charge for their product. However, these firms also face competition, and due to
free entry and exit in the long run will find that their long-run economic profit is
equal to zero. There is no tendency toward collusion in a monopolistically
competitive market since all firms recognize that new firms can enter the industry
in the long run.
Objective #3. Product differentiation takes three general forms: differentiation by
style or type, differentiation by location, and differentiation by quality.
Differentiation by style or type creates products that are imperfect substitutes for
one another. Differentiation by location offers essentially identical products that are
differentiated by their proximity and convenience to the buyer. Differentiation by
quality provides a range of products that are of different quality levels to buyers. No
matter what type of product differentiation we consider, the monopolistically
competitive market structure is characterized by competition among sellers and a
more diverse array of products.
Objective #4. In the short run, a monopolistically competitive firm produces the
level of output where marginal revenue equals marginal cost (MR = MC) and then
prices this output by going up to its demand curve. The monopolistically
competitive firm's MR curve lies beneath its demand curve (you find it exactly the
same way you found the MR curve for the monopoly). This firm will earn positive
economic profits if price is greater than average total cost, and negative economic
profits if price is less than average total cost. The monopolistically competitive firm
acts exactly like a monopoly in the short run. Figure 16.1 illustrates a
monopolistically competitive firm in the short run earning positive economic
profits, while Figure 16.2 illustrates a monopolistically competitive firm in the short
run earning negative economic profits.
Objective #5. In the long run, the monopolistically competitive firm earns zero
economic profit due to the entry or exit of firms.
• If the monopolistically competitive firm earns positive economic profit in the
short run, this acts as a signal for other firms to enter the industry. The entry of
firms into the industry causes the demand curve for each existing firm to shift to
the left so that at every price fewer units of their product are demanded. This
process continues until there has been enough entry so that each firm's price
equals average total cost. Figure 16.3 illustrates both the short-run and the longrun equilibrium for a monopolistically competitive firm with positive economic
profits in the short run. Notice that this firm produces a smaller level of output
and sells its good at a lower price in the long run than it did in the short run.
•
If the monopolistically competitive firm earns negative economic profit in the
short run, this acts as a signal for some of the firms in the industry to exit in the
long run. This exit of firms from the industry causes the demand curve for each
remaining firm to shift to the right so that at every price more units of their
product are demanded. This process continues until there has been enough
exiting so that each remaining firm's price equals its average total cost. Figure
16.4 illustrates both the short-run and the long-run equilibrium for a
monopolistically competitive firm with negative economic profits in the short
run. Notice that this firm produces a higher level of output and sells this output
at a higher price in the long run than it did in the short run.
•
If the monopolistically competitive firm earns negative economic profit in the
short run, this acts as a signal for some of the firms in the industry to exit in the
long run. This exit of firms from the industry causes the demand curve for each
remaining firm to shift to the right so that at every price more units of their
product are demanded. This process continues until there has been enough
exiting so that each remaining firm's price equals its average total cost. Figure
16.4 illustrates both the short-run and the long-run equilibrium for a
monopolistically competitive firm with negative economic profits in the short
run. Notice that this firm produces a higher level of output and sells this output
at a higher price in the long run than it did in the short run.
Objective #6. In the long run, each firm in a monopolistically competitive industry
acts like a monopolist in setting marginal revenue equal to marginal cost and
producing the quantity of output so as to maximize profits. However, in the long
run the producers earn zero economic profits, unlike the long-run result for
monopoly.
Objective #7. The long-run equilibrium in monopolistic competition also
resembles the perfect competition result, since firms earn zero economic profit and
their price equals average total cost. But there is a critical difference between longrun equilibrium in perfect competition and long-run equilibrium in a
monopolistically competitive industry: in perfect competition, price is equal to the
minimum of average total cost, while in monopolistic competition, price is equal to
average total cost but not at the minimum-cost point of the average total cost (ATC)
curve. The monopolistically competitive firm has excess capacity in the long
run even though it earns zero economic profit; this excess capacity is another way
of saying that the monopolistically competitive firm is not producing at minimum
cost. This excess capacity of the monopolistically competitive firm arises from the
cost of providing variety in the industry: the excess capacity is a sign of wasteful
duplication that could be eliminated if there were fewer firms in the industry
offering less-differentiated products. Yet consumers enjoy this diversity of products
and it is valuable to them.
Objective #8. In the long run, the perfectly competitive firm produces at a level
where price equals marginal cost, while the monopolistically competitive firm
produces at a level where price is greater than marginal cost. The monopolistically
competitive firm in the long run is interested in selling more units of the good,
since price is greater than marginal cost for the last unit produced. This helps us
understand why monopolistically competitive firms advertise their product.
Objective #9. Advertising is worthwhile in industries where firms have some
degree of market power. Advertising may help to establish the quality of a firm's
product. Advertising may also convey important information. The establishment of
a brand name may be a way of signaling quality to a consumer.
Key Terms
monopolistic competition a market
structure in which there are many
competing producers in an industry, each
producer sells a differentiated product, and
there is free entry and exit into and from
the industry in the long run.
zero-profit equilibrium an economic
balance in which each firm makes zero
profit at its profit-maximizing quantity.
excess capacity when firms produce less
than the output at which average total cost
is minimized; characteristic of
monopolistically competitive firms.
brand name a name owned by a particular
firm that distinguishes its products from
those of other firms.
Notes
AFTER YOU READ THE CHAPTER
Tips
Tip #1. Monopolistic competition is an odd blend of elements from the monopoly
model and from the perfect competition model. It is important that you understand
these elements and how they work. Let's start with an analysis of the short-run
situation. First, the monopolistically competitive firm faces a downward-sloping
demand curve and, therefore, a MR curve that is beneath its demand curve. This is
like monopoly. Second, the monopolistically competitive firm profit maximizes by
producing the quantity where MR = MC This is like both perfect competition and
monopoly. Third, the price the monopolistically competitive firm charges for its
good is found by taking the profit-maximizing quantity and looking at the demand
curve for the price associated with that quantity. This is exactly what a monopoly
does. In the short run, the monopolistically competitive firm exactly mimics the
behavior of a monopoly. So, just remember your work with monopoly and apply
those same rules. In the short run, the monopolistically competitive firm can earn
positive, negative, or zero economic profit.
Tip #2. In the long run, the monopolistically competitive firm is subject to entry of
new firms into the industry and the exit of existing firms from the industry. This is a
characteristic that makes the monopolistically competitive industry resemble
perfect competition. But there's an important distinction: even though economic
profit equals zero in the long run for both market structures, the monopolistically
competitive firm faces a downward-sloping demand curve, which means that price
and marginal revenue are not the same for this firm. It implies that even when the
monopolistically competitive firm earns zero economic profit in the long run, it
charges a price that is greater than its marginal cost. This is different from the result
found in perfect competition. Also, in perfect competition in the long run, price =
MR = MC= minimum ATC. In monopolistic competition in the long run, MR = MC
and price = ATC, but price is not equal to marginal cost and price is not equal to
the minimum average total cost. Review these two tips thoroughly until you have
mastered them and understand the implications of the points made in each tip.