L17 - Monopolistic Competition

Question 1

What are the assumptions of Monopolistic Competition?

Answer 1

1) Buyers are price takers
2) Sellers and Buyers have complete information
3) Product Differentiation

4) Sellers are price makers
(a) A seller sells more when its price is lower
(b) the seller’s output choice does not trigger a
reaction its rivals

5) Free Entry/Exit

Question 2

What are the types of Product Differentiation?

Answer 2

(1) Horizontal differentiation
quality is the same but the best depends on tastes

(2) Vertical differentiation
quality differs…

Question 3

What does it mean that sellers are symmetric?

Answer 3

For costs: this means their cost curves are the same shape
For demand: it is less realistic but it simplifies things considerably

E.G: 4000 people who regularly frequent 40 pubs
At the market price, each pub would have 100 people (= 4000 people/40 pubs)

Question 4

What happens to factors of production and sellers in the long run?

Answer 4

(a) all factors are variable which has an impact on the seller’s costs
(b) other sellers can freely enter the market

Question 5

At what point is the zero profit condition in the long run?

Answer 5

When P(LR)= AR(LR)= LRAC

Question 6

Differences between Perfect Competition and Monopolistic Competition?

Answer 6

1) Price-cost Margin
Monopolistic competition: price is above marginal
cost, even in the long run
Perfect competition: price equals marginal cost

2) Excess Capacity
Perfectly competitive sellers produce at the efficient
scale.
Monopolistically competitive sellers do not. Thus,
having excess capacity.

Efficient scale of the firm:

A seller’s output is smaller than the level that minimises average total costs

Question 7

Is there deadweight loss in Monopolistic?

Answer 7

Yes.

Some buyers will be deterred from purchasing

Question 8

Is the number of firms in the market ‘ideal’?

Answer 8

Depend on the effect on total welfare of the last seller entering the market:

(a) Product-variety effect: consumer surplus increases
another seller provides more choice: the more, the better

(b) Business-stealing effect: producer surplus decreases another seller reduces profits of all other sellers

If (a) is greater than (b): too few! If (a) is less than (b): too many!
If (a) equals (b): ideal number!

Question 9

Is Excess Capacity bad for welfare?

Answer 9

Excess capacity implies that variety is costly. This is only a bad for welfare
if product variety is not valued.