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CHAPTER 16
Monopolistic Competition and
Product Differentiation
What you will learn in this chapter:
The meaning of monopolistic competition
Why oligopolists and monopolistically competitive
firms differentiate their products
How prices and profits are determined in
monopolistic competition in the short run and the
long run
Why monopolistic competition poses a trade-off
between lower prices and greater product diversity
The economic significance of advertising and brand
names
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The Meaning of Monopolistic Competition
Monopolistic competition is a market structure in
which
there are many competing producers in an industry,
each producer sells a differentiated product, and
there is free entry into and exit from the industry in
the long run.
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Product Differentiation
Product differentiation plays an even more crucial role
in monopolistically competitive industries. Why?
Tacit collusion: is it possible?
Product differentiation  market power.
Then, how do firms in the same industry differentiate
their products? E.g. hotels in Vung Tau
Is the difference mainly in the minds of consumers or
in the products themselves?
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Product Differentiation
There are three important forms of product
differentiation:
Differentiation by style or type
SUV’s
–
Sedans vs.
Differentiation by location – hair-dressers near
home vs. Cheaper hair-dressers far away
Differentiation by quality – Ordinary ($) vs.
gourmet chocolate ($$$)
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Product Differentiation
Whatever form it takes, however, there are two
important features of industries with differentiated
products:
Competition
among sellers: entry by more producers
reduces the quantity each existing producer sells
Value
in diversity: consumers gain from the
increased diversity of products.
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Economics in Action:
Case: “Any Color, So Long as It’s Black”
Ford’s strategy was to offer just one style of car,
which maximized his economies of scale but made
no concessions to differences in taste  Model T
Alfred P. Sloan of GM challenged this strategy by
offering a range of car types, differentiated by
quality and price  Chevrolet, Cadillac, Buick…
By the 1930s the verdict was clear: Customers
preferred a range of styles!
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Understanding Monopolistic Competition
Combines some features typical of monopoly
with others typical of perfect competition:
Each firm is offering a distinct product like a
monopolist (downward-sloping demand curve & has
some market power)
Unlike a pure monopolist, a monopolistically
competitive firm does face competition.
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The firm in panel (a) can be profitable
for some output levels: the levels at
which its ATC, lies below its demand
curve, DP. The profit-maximizing
output level is QP, the output at which
marginal revenue, MRP, is equal to
marginal cost. The firm charges price
PP and earns a profit, represented by
the area of the shaded rectangle.
The firm above can never be
profitable because the ATC lies
above its demand curve, DU. The
best that it can do if it produces at
all is to produce output QU and
charge PU. This generates a loss,
indicated by the area of the shaded
rectangle. Any other output level
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results in a greater loss.
Monopolistic Competition in the Long Run
If the typical firm earns positive profits, new firms will
enter the industry in the long run, shifting each
existing firm’s demand curve to the left. If the typical
firm incurs losses, some existing firms will exit the
industry in the long run, shifting the demand curve of
each remaining firm to the right.
In the long run, equilibrium of a monopolistically
competitive industry, the zero-profit-equilibrium, firms
just break even. The typical firm’s demand curve is just
tangent to its average total cost curve at its profitmaximizing output.
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Entry and Exit into the Industry Shift the Demand Curve
of Each Firm
Entry will occur in the long run when existing firms are profitable. In panel (a),
entry causes each firm’s demand curve and marginal revenue curve to shift to the
left. The firm receives a lower price for every unit it sells, and its profit falls. Entry
will cease when remaining firms make zero profit.
Exit will occur in the long run when existing firms are unprofitable. In panel (b), exit
out of the industry shifts each remaining firm’s demand curve and marginal revenue
curve to the right. The firm receives a higher price for every unit it sells, and profit
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rises. Exit will cease when the remaining firms make zero profit.
The Long-Run
Zero-Profit
Equilibrium
A monopolistically
competitive firm is like a
monopolist without
monopoly profits.
If existing firms are profitable, entry will occur and shift each
firm’s demand curve leftward. If existing firms are unprofitable,
each firm’s demand curve shifts rightward as some firms exit the
industry. In long-run zero profit equilibrium, the demand curve of
each firm is tangent to its average total cost curve at its profitmaximizing output level: at the profit-maximizing output level,
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QMC, price, PMC, equals average total cost, ATCMC.
Monopolistic Competition versus
Perfect Competition
In the long-run equilibrium of a monopolistically
competitive industry, there are many firms, all
earning zero profit.
Price exceeds marginal cost so some mutually
beneficial trades are exploited.
The following figure compares the long-run
equilibrium of a typical firm in a perfectly competitive
industry with that of a typical firm in a
monopolistically competitive industry.
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Panel (a) shows the situation of the typical firm in long-run equilibrium in a perfectly
competitive industry. The firm operates at the minimum-cost output QC , sells at the
competitive market price PC , and makes zero profit. It is indifferent to selling another
unit of output because PC is equal to its marginal cost, MCC .
Panel (b) shows the situation of the typical firm in long-run equilibrium in a
monopolistically competitive industry. At QMC it makes zero profit because its price, PMC,
just equals average total cost. At QMC the firm would like to sell another unit at price
PMC, since PMC exceeds marginal cost, MCMC. But it is unwilling to lower price to make
more sales. It therefore operates to the left of the minimum-cost output and has excess
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capacity.
Is Monopolistic Competition Inefficient?
Firms in a monopolistically competitive industry have
excess capacity: they produce less than the output
at which average total cost is minimized.
The higher price consumers pay because of excess
capacity is offset to some extent by the value they
receive from greater diversity.
Hence, it is not clear that this is actually a source of
inefficiency.
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Controversies about Product
Differentiation
No discussion of product differentiation is complete
without spending at least a bit of time on the two
related issues—and puzzles—of:
advertising
and
brand names
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The Role of Advertising
In industries with product differentiation, firms
advertise in order to increase the demand for their
products.
Advertising is not a waste of resources when it gives
consumers useful information about products.
Advertising that simply touts a product is harder to
explain.
Either consumers are irrational, or expensive
advertising communicates that the firm's products are
of high quality.
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Brand Names
Some firms create brand names.
A brand name is a name owned by a particular firm
that distinguishes its products from those of other
firms.
As with advertising, the social value of brand names
can be ambiguous.
The names convey real information when they assure
consumers of the quality of a product.
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