Download In this lesson, we`re going to explain how monopolistic competition

Other Market Models
Monopolistic Competition
Understanding Pricing and Output Under Monopolistic Competition
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In this lesson, we’re going to explain how monopolistic competition works and I’m going to do it using some graphs
that are familiar, but I’m going to use them in an unfamiliar way. Let’s look at the situation that faces a single fast food
restaurant selling hamburgers. This fast food restaurant has been able to achieve a downward sloping demand curve
by differentiating its products from the hamburgers of competitor restaurants. Maybe they have more sesame seeds
on their bun, maybe they advertise harder, maybe they have some kind of special promotion that make their
restaurants look fun, something like that. But, for whatever reason, you believe as a customer that this product is not
a perfect substitute for other hamburgers. Therefore, you’re willing to stay with this firm, even when they raise their
price or if competitors lower their price, you won’t defect and buy the other product.
Product differentiation gives this firm a kind of monopoly. They are the only providers of their particular brand of fast
food hamburger. Because they have a downward sloping demand curve, they also have a marginal revenue curve,
like any firm with market power. And remember, marginal revenue is always less than price, because in order to sell
another hamburger, you have to lower the price that you could have charged for a smaller number of burgers and
earned more money on them. So marginal revenue is declining and is below the demand curve.
Finally, notice, I’ve put in the cost curves for producing hamburgers. This fast food restaurant experiences increasing
marginal cost as it produces more hamburgers, due to diminishing labor productivity. And the average cost curve lets
us determine whether the firm is making a profit or not. So, looking at this diagram, we can describe the firms
behavior the way we would describe the behavior of any monopolist. This hamburger restaurant in going to produce
the quantity of hamburgers that makes marginal cost equal to marginal revenue. So, here’s the quantity of
hamburgers produced right here. If we follow up to the demand curve, we see the price that this firm would be
charging for its hamburgers and since price is greater than average cost, this firm is making a profit. And the amount
of profit would be price minus average cost multiplied by the number of hamburgers produced.
You’ve seen all of this before and we’ve given you a little reminder over on the board to help you remember how a
monopoly is described, the choice of the quantity, the choice of the price and the profits that are earned. Now, here’s
where the model gets new and interesting. Instead of assuming that there is no entry into this market, let’s imagine
that there is free entry. The cost of entering the market is the cost of differentiating your product from that of
competitors. We could have anybody start up their own fast food chain, as long as they can persuade customers that
the hamburger that they sell is somehow different than the other burgers that are out there on offer.
Once you’ve got a new burger that you’ve defined in the minds of customers as somehow unique, then you’ve got
your own downward sloping demand curve, you’ve got your own little monopoly, a monopoly in a market that you’ve
created by product differentiation, either through advertising or other small changes in the nature of the products.
Well, think about this. One chain has its little chunk of the market, another chain has its little chunk of the market, a
third chain has its little chunk of the market and if you add up all the demands for all of these different kinds of
hamburgers you get the total demand for hamburgers in the market.
See what’s happening is, out there in the market, there is a demand for hamburgers and firms are satisfying that by
producing hamburgers and selling them, but in order to get more profit the firms are differentiating their products from
each other. And when they do that, they have a downward sloping demand curve for their particular variety of
hamburgers. However, it’s not that we could get an infinite number of hamburgers. There’s not any way that the
market would support 80 or 90 different particular kinds of fast food burger. That’s because there’s not enough
demand in the market to support that many different chains.
However, if you look at the diagram that I’ve drawn here, there’s certainly room for at least one more chain. How do
you know, how do you know by looking at this diagram that another chain could enter with a differentiated hamburger
and still make a profit. You know because, in this situation, the firms that are already in the market, this being one of
them, are making extra profits. They’re making economic profits. So, firms will enter to try to take some of the market
share and when they enter, they’ll be creating a new differentiated product.
So, what happens then, when a competitor enters this market? Is the share that’s left for our particular hamburger
shrinks? Once a new burger is created, some people will be persuaded that it is the best burger. It will become their
burger of choice and they’ll switch to it. What happens then, is the market share of our little firm shrinks. The market
share of our particular fast food restaurant shrinks. The demand curve moves inward and with it the marginal revenue
Other Market Models
Monopolistic Competition
Understanding Pricing and Output Under Monopolistic Competition
Page 2 of 2
curve and as that changes, as demand shifts inward and marginal revenue comes with it, the firm adjusts its profit
maximizing output.
With a smaller market share, now, the firm is going to produce a smaller quantity of burgers and change the price that
it charges and perhaps make a different amount of profit than before. Again, what caused the curves to shift? The
curve for your particular fast food chain shifts inwards when a new chain enters the market and claims a share. It
says, “Hey, there’s enough to go around.” And it appears that there is, because your firm is still making enough
money to cover its average cost.
However, I shifted the curves so that we have arrived at a new equilibrium. Notice, the equilibrium has the firm
producing where price equals—where marginal revenue equals marginal cost and price is on the demand curve. But
here’s something that’s true, in this case, that wasn’t true before. Price is now equal to average cost and when price
is equal to average cost the firm is breaking even. There’s no room for any more hamburger chains in this market.
Every hamburger chain has entered, distinguished itself and claimed a chunk of the market.
Now the firms are just breaking even as they would in a competitive equilibrium. Ah-ha. That’s why we call this
monopolistic competition. Monopoly, because of the downward sloping demand curve, the market power, the
marginal revenue, marginal revenue equals marginal cost, all that’s familiar from our model of monopoly. But we call
it competition, because free entry occurs. That is, firms continue to enter this market with distinguished products until
price is equal to average cost, until the demand curve is tangent to the average cost curve. At that point, price equals
average cost, firms are breaking even and there will be no further entry. We now have an equilibrium in a
monopolistically competitive market.
So, is that good or is it bad? Well, it depends. It depends on what you like. The advantage of monopolistic
competition is we get a whole lot of variety, all different kinds of hamburgers, at least if you can recognize the variety,
it’s there. One the other hand, the cost to customers is, instead of arriving at this point of minimum average cost, the
way that we do in a competitive market, we wind up on a downward sloping portion of the average cost curve.
Average cost never falls all the way down to its lowest level, the way it would in a competitive market. Costs are
higher in a monopolistically competitive industry. Costs are higher and there’s still a bit of a deadweight loss, like in
any monopoly.
But that turns out to be the price we pay for the variety that monopolistic competition delivers. If you like variety, more
than a little extra efficiency, monopolistic competition is a great bargain. On the other hand, you’ve got to recognize
the deadweight loss is still there and the firm never gets to minimum average cost. So, a quick review. Monopolistic
competition has firms behaving as monopolies, but the additional element is free entry. Firms can enter, creating their
own new little chunk of monopoly until the market doesn’t have room for any more of them, until the market share of
an individual firm is just enough to cover the average cost of producing the burgers they sell.