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Chapter 16 Monopolistic Competition
A. Monopolistic Competition
1. Def: A monopolistically competitive market is one with:
(a) Many small sellers – none can affect market individually, but they can change their
prices. Collusion is impossible given the large number of firms.
(b) differentiated product – there are differences, perceived or real, that gives brand
identity to a product.
-Non-price competition – when firms compete through advertising (i.e. packaging,
quality, etc...)  helps to erode profits in the LR.
(c) easy entry and exit with little or no barriers  leads to no economic profit in the LR
(i.e. it makes market rates of return)
2. Identification of Monopolistic Competition:
-we use market/industry concentration indices to tell us if we are dealing with
monopolistic competition or not. Industry concentration gives us an idea of how much
disparity there is between the largest and smallest firms.
Measure used
a. Four-Firm Concentration Ratio – the fraction of the total industry that is generated
from the largest 4 firms in the industry. The greater the measure the larger the
concentration they make up.
Mathematically:
S  S 2  S3  S 4
i. C4 = 1
ST
Si- refers to the sales of the ith firm with ST being the total sales in the market. We could
also use market share, denoted w, where wi = Si/ ST. This changes our expression to:
ii. C4 = w1 + w2 + w3 + w4
**A ratio of 40% or less indicates a high degree of competition and probably
Monopolistic Competition.
b. Herfindahl-Hirshman Index – another measure of concentration which uses the sum of
squared market shares as a measure of concentration. It is the sum over the top 50 firms
(or less if there are less than 50)
Mathematically: HHI = 10,000 Σ wi2
-note that the value ranges from 0 to 10,000 with a value of 10,000 indicating only one
firm and a value at or near 0 indicating infinitely many firms.
-See page 411 for a comparison of the two measures along with values for various
industries…a value of around 1800 generally indicates monopolistic competition.
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c. Limitations of these measures
(1) Global markets and global competitors are largely ignored. This tends to bias
measures upward.
(2) The local vs. national bias. If a firm is local although it may be compared to national
firms, the measure does very little to tell us about the local competitive environment.
(3) The way in which we define a market (i.e. how broad or narrow) as well as what
product class we put a good in also affects the measure. This is up to the firm and
managers to make these decisions in order to obtain the appropriate measures.
-Firms compete on quality, price, and marketing.
3. Demand Curve of a Monopolistic Competitor (more to scale)
- it is more elastic than a monopolist, but less than for perfect competition
- Due to product differentiation firms do have some pricing power, but if they raise prices
too high then demand would be 0.
-Notice that in this case a monopolistic competitor’s demand curve is flatter than a
monopolists but still downward sloping
Graphically: P
DPC
Dmonoploly
Dmon. comp
Q
4. Price and Output Decisions for Mon. Competition
- in the SR we can have profits, but in the LR if there is no differentiation perceived then
it erodes to 0 just as in perfect competition.
a. SR – we set price just as in monopoly, noting that the MR and Demand should be more
elastic and farther out as we have demonstrated above.
Graphically: P
MC ATC
Price
Cost
Dmon. comp
Q
MR
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Note: Just as in all other markets it is not guaranteed that there are (+) profits in the
market. Could be +, -, or zero.
LR – in the long run firms are allowed to enter. This shifts demand curve for the
individual firm to the left and makes it flatter (more elastic) just like perfect competition.
Graphically: P
MC ATC
PLR
D1
MR2
Q
D2
MR1
Note:
(1) that Q drops for the firm since the increased competition takes away from their sales.
(2) There might be LR profits if the firms can differentiate its product. Since it does this
through the use of advertising, this is not socially optimal. It artificially raises prices for
the good and lowers quantity w/o providing any real benefit.
Recall: this would shift the ATC curve up and when the costs go up without changing
demand for the good. The only real benefit for advertising is more information, but it
comes from a biased point of view.
Terms:
i- Excess capacity – this is the idea of how much a firm produces that is less than efficient
scale (i.e. min of ATC)
ii-Markup- the amount by which price exceeds MC
Graphically:
MC ATC
MR
PLR
Mark-up
D-LR
Q*
Q-EfficientScale
Excess Capacity
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Q
5. Comparison with PC in the LR: A Firm Comparison
Graphically:
a. Monopolistic Competition
P
MC ATC
PLR
DLR
Q
QMonComp MRLR
b. Perfect Competition
P
MR = Dfirm = Price Market
Q
QPC
-there is still an underutilization of resources due the fact that:
(1) QMonComp < QPC and
(2) The prices that are charged in MC is are higher  PMonComp > PPC
(3) Price exceeds MC in the MonComp market while in the PC we have price exactly
equal to MC & at the minimum of ATC.
6. Additional Issues
-If a firm is to continue making economic profits in the LR it must differentiate its
product. This comes from developing new products and advertising. A company must
weigh the costs and benefits of doing so.
-As costs go up for advertising and R&D this can affect costs which in turn may affect
both the supply and demand for the product.
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-Many times large advertising campaigns are signals (action taken by informed agent to a
less informed agent) to the public that the product is better or of a higher quality. This is
the concept of branding or brand names.
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