CHAPTER 13: Monopolistic Competition

Question 1

Monopolistic Competition

Answer 1

○ A large number of firms compete
○ Each firm produces a differentiated product
○ Firms compete on product quality, price, and marketing
○ Firms are free to enter and exit the industry

Question 2

In monopolistic competition, the industry consists of a large number of firms. What are 3 implications of this characteristic?

Answer 2

1. Small Market Share - each firm supplies a small part of the total industry output
   - limited influence on price
2. Ignore other firms - All the firms are relatively small, so no one firm can dictate market conditions and the actions of no one firm can directly affect the actions of other firms
3. Collusion Impossible - coordination is difficult and the collusion is not possible

Question 3

What is product differentiation?

Answer 3

• A firm practices product differentiation if it makes a product that is slightly different from the products of competing firms
• is close to a substitute but not a perfect substitute for the products of the other firms.

Question 4

Product differentiation enables a firm to compete w/ other firms in what 3 areas?

Answer 4

product quality, price, and marketing

Question 5

What is the long-run implication for monopolistic competition if the market no barriers to prevent new firms from entering the industry?

Answer 5

Cannot make economic profit
○ When existing firms make economic profit, new firms enter the industry
○ This entry lowers prices and eventually eliminates economic profit
○ Once firms leave due to lack of economic profit, prices rise and economic losses are eliminated

Question 6

What are 2 measures of concentration in identifying monopolistic competition?

Answer 6

○ The four-firm concentration ratio
○ The Herfindahl Hirschman index

Question 7

The four-firm concentration ratio

Answer 7

% of the total revenue accounted for by the four largest firms in an industry.

• This ranges from almost 0- perfect competition to 100- monopoly
• This is the main measure used to assess market structure
• LOW concentration ratio- indicates high degree of competition
• HIGH concentration ratio- indicates an absence of competition

Question 8

The Herfindahl Hirschman index

Answer 8

HHI is the square of the percentage market share of each firm summed over the largest 50 firms in a market

E.g. if there are four firms in a market and the market shares of the firms are 50%, 25%, 15%, 10%, the HHI is: HHI= 50^2 + 25^2 + 15^2 + 10^2 = 3450

• In perfect competition, the HHI is small
• HHI between 1500 and 2500= a competitive market
• HHI 2500 or higher is concentrated and non-competitive (oligopoly)

Question 9

What are 2 key differences between monopolistic competition & perfect competition?

Answer 9

• Excess capacity - a firm has excess capacity if it produces less than its efficient scale (quantity at which ATC is a minimum - bottom of u-shaped ATC)
  ○ ATC is the lowest possible cost only in perfect competition
• Markup - amount by which price exceeds marginal cost
  ○ In perfect competition, marginal cost = price therefore no mark-up
  ○ In monopolistic competition, buyers pay a higher price & pay more than marginal cost

Question 10

Is Monopolistic Competition Efficient?

Answer 10

• Efficient when marginal social benefit = marginal social cost

Bottom Line - Product variety is both valued and costly. The efficient degree of product variety is the one for which marginal social benefit of product variety equals its marginal social cost

○ the loss that arises because the quantity produced is less than the efficient quantity is offset by the gain that arises from having a greater degree of product variety.

So compared to the alternative- product uniformity- monopolistic competition might be efficient.

Question 11

What is the purpose of product development?

Answer 11

developing new and improved products to stay ahead of imitating firms

Question 12

How do monopolistic competitive firms achieve profit-maximizing development?

Answer 12

○ The firm must balance the cost of product development with additional revenue at the margin.
○ The marginal dollar spent on developing a new or improved product is the marginal cost of product development
○ The marginal dollar that the new or improved product earns for the firm is the marginal revenue of product development
○ At a low level of product development, the marginal revenue from a better product exceeds marginal cost
○ At a high level of production, the marginal cost of a better product exceeds the marginal revenue
○ When the marginal cost and marginal revenue are equal, the firm is undertaking the profit maximizing amount of product development
○ Efficiency is achieved if the marginal social benefit of a new and improved product equals marginal social cost