Chapter 16: Monopolistic Competition

A market structure that does not meet the conditions of perfect competition and monopoly.

A market structure in which only a few sellers offer similar or identical products.

The percentage of total output in the market supplied by the four largest firms.

A market structure in which many firms sell products that are similar but not identical. It lies between the cases of perfect competition and a monopoly. Each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers.

Many sellers: There are many firms competing for the same group of customers. Product differentiation: Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve. Free entry and exit: Firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero.

The first question to ask about any market is how many firms there are. If there is only one firm, the market is a monopoly. If there are only a few firms, the market is an oligopoly. If there are many firms, we need to ask another question: Do the firms sell identical or differentiated products? If the many firms sell identical products, the market is perfectly competitive. But if the many firms sell differentiated products, the market is monopolistically competitive.

A monopolistically competitive firm chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price at which it can sell that quantity.

Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal revenue equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is greater than average total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost.

Profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms' products falls, these firms experience declining profit. Losses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms' products rises, these firms experience rising profits (that is, declining losses).

As in a monopoly market, price exceeds marginal cost (P > MC). This conclusion arises because profit maximization requires marginal revenue to equal marginal cost (MR = MC) and because the downward-sloping demand curve makes marginal revenue less than the price (MR < P). As in a competitive market, price equals average total cost (P = ATC). This conclusion arises because free entry and exit drive economic profit to zero.

Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-run equilibrium in a perfectly competitive market. Two differences are notable. (1) The perfectly competitive firm produces at the efficient scale, where average total cost is minimized. By contrast, the monopolistically competitive firm produces at less than the efficient scale. (2) Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition.

The difference between a firm's profit-maximizing quantity and the quantity that minimizes average cost.

Price exceeds marginal cost because the firm always has some market power. In the long-run equilibrium, monopolistically competitive firms operate on the declining portion of their average-total-cost curves, so marginal cost is below average total cost.

Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. That is, the invisible hand does not ensure that total surplus is maximized under monopolistic competition. Yet because the inefficiencies are subtle, hard to measure, and hard to fix, there is no easy way for public policy to improve the market outcome.

Firms that sell highly differentiated consumer goods, such as over-the-counter drugs, perfumes, soft drinks, razor blades, breakfast cereals, and dog food, typically spend between 10 and 20 percent of their revenue on advertising. Firms that sell industrial products, such as drill presses and communications satellites, typically spend very little on advertising. And firms that sell homogeneous products, such as wheat, salt, sugar, and crude oil, spend nothing at all. For the economy as a whole, about 2 percent of total firm revenue is spent on advertising.

Critics argue that advertising manipulates people's tastes to create a desire that otherwise would not exist and that advertising impedes competition by increasing the perception of product differentiation, which increases brand loyalty, causes demand to be more inelastic, and allows the firm to charge a greater markup over marginal cost.

Defenders of advertising argue that advertising provides information to customers about prices, the existence of new products, and the location of retail outlets. This information increases competition because consumers are aware of price differentials and it provides new firms with the means to attract customers from existing firms. Evidence suggests that advertising increases competition and reduces prices for consumers.

Firms are likely to spend a great deal on advertising only if they think their product is of high quality.

Advertising is related to brand names. Critics of brand names argue that brand names cause consumers to perceive differences between goods that do not exist. Defenders of brand names argue that brand names ensure that the product is of high quality because; - Brand names provide information about the quality of a product. - Brand names give firms the incentive to maintain high quality.