11.2 Monopolistic Competition Flashcards
What is monopolistic competition?
Market structure of an industry in which there are many firms and freedom of entry and exit but in which each firm has a product somewhat differentiated from the others, giving it some control over its price.
This market structure is similar to perfect competition in that the industry contains many firms and exhibits freedom of entry and exit. It differs, however, in one important respect:
Whereas firms in perfect competition sell an identical product and are price takers, firms in monopolistic competition sell a differentiated product and thus have some power over setting price.
How is this market structure similar to perfect competition? How does it differ?
This market structure is similar to perfect competition in that the industry contains many firms and exhibits freedom of entry and exit.
It differs, however, in one important respect: Whereas firms in perfect competition sell an identical product and are price takers, firms in monopolistic competition sell a differentiated product and thus have some power over setting price.
The theory of monopolistic competition is based on four key simplifying assumptions:
Each firm produces its own version of the industry’s differentiated product. Each firm thus faces a demand curve that, although negatively sloped, is highly elastic because competing firms produce many close substitutes.
All firms have access to the same technological knowledge and so have the same cost curves.
The industry contains so many firms that each one ignores the possible reactions of its many competitors when it makes its own price and output decisions. In this respect, firms in monopolistic competition are similar to firms in perfect competition.
There is freedom of entry and exit in the industry. If profits are being earned by existing firms, new firms have an incentive to enter. When they do, the demand for the industry’s product must be shared among the increased number of firms.
The short-run position of a monopolistically competitive firm is similar to that of a monopolist…
profits can be positive, zero, or negative.
What kind of profits and capacity does a monopolistically competitive industry have in the long run?
In the long run, firms in a monopolistically competitive industry have zero profits and excess capacity.
To see why this “tangency solution” provides the only possible long-run equilibrium for an industry that fulfills all of the theory’s assumptions, consider the two possible alternatives…
First, suppose the demand curve for each firm lies below and never touches its LRAC curve. There would then be no output at which costs could be covered, and firms would leave the industry. With fewer firms to share the industry’s demand, the demand curve for each remaining firm shifts to the right. Exit will continue until the demand curve for each remaining firm touches and is tangent to its LRAC curve.
Second, suppose the demand curve for each firm cuts its LRAC curve. There would then be a range of output over which positive profits could be earned. Such profits would lead firms to enter the industry, and this entry would shift the demand curve for each existing firm to the left until it is just tangent to the LRAC curve, where each firm earns zero profit.
It is clear that monopolistic competition results in a long-run equilibrium of zero profits, even though each individual firm faces a negatively sloped demand curve. How does it do this?
It does this by forcing each firm into a position in which it has excess capacity; that is, each firm is producing an output less than that corresponding to the lowest point on its LRAC curve.
What is the excess-capacity theorem?
The property of long-run equilibrium in monopolistic competition that firms produce on the falling portion of their long-run average cost curves. This results in excess capacity, measured by the gap between present output and the output that coincides with minimum average cost.
Where does the tradeoff lay?
From society’s point of view, there is a tradeoff between producing more brands to satisfy diverse preferences and producing fewer brands at a lower cost per unit.
