Week 6: Monopolistic Competition

Question 1

Monopolistic competition model summary

Answer 1

• The Monopolistic competition model combines elements of both monopoly and perfect competition.
• in the model, many firms produce similar but differentiated products.
• Firms have some degree of market power but face competition due to the availability of substitutes.

Question 2

monopoly

Answer 2

• A single firm controls the entire market for a specific good
• it has perfect control over the market price of this good

Question 3

Duopoly

Answer 3

• Two firms control the entire market for a specific good
• the demand faced by each firm is affected by the price charged by the
  other firm.

Question 4

Monopolistic competition Assumption 1

Answer 4

• Firms produce similar but differentiated goods.
• Each firm faces downward-sloping demand and has some pricing power

Question 5

Monopolistic competition Assumption 2

Answer 5

• Many firms in the industry.
• Each firm’s demand share is D/N if prices are equal.
• When only one firm lowers its price, however, it will face a flatter demand curve d

Question 6

Monopolistic competition Assumption 3

Answer 6

• Firms produce using a technology with increasing returns to scale
• thus, average cost decreases with higher output.
• (MC is assumed to be constant for simplicity)
• Labour and capital have constant returns to scale.

Question 7

Monopolistic competition Assumption 4

Answer 7

• Firms can freely enter and exit the industry
• (Firms enter while monopoly profits are possible, reducing profits per firm.)
• (Long-run profits become zero, similar to perfect competition.)

Question 8

Monopolistic competition Assumption 5

Answer 8

• only used in trade
• home and foreign are exactly the same
• under monopolistic competition they will trade

Question 9

Monopoly profits

Answer 9

• Whenever
  P > AC, the firm earns monopolyprofits. 13

Question 10

Monopolistic competition: No trade (short run)

Answer 10

• ( demand curve) Firms face a downward-sloping demand curve (d₀), similar to a monopoly
• (poduction (Q₀)) Each firm produces at (Q₀) where marginal revenue (mr₀) = marginal cost (MC).
• (price p(₀)) The corresponding market price is p(₀)
• firms earn monopoly profits

.

Question 11

Monopolistic competition: No trade (Long run)

Answer 11

• Monopoly profits in the short run attract new firms to the market.
• Firm demand curve (d₀ -> d₁ shifts left and becomes more elastic due to increased competition.
• the MR curve shifts inward as firms’ ability to generate additional revenue diminishes as demand decreases
• Long-run equilibrium occurs at Q₁ , where
  mr₁ =MC.
• In the long run, firms earn zero economic profits as price (p^A) = average cost (AC).
• Firms enter until monopoly profits are eliminated.

Question 12

Monopolistic competition: Trade (short run) initial point

Answer 12

• Initial Point: Home and Foreign markets are in long-run equilibrium without trade, with:
• Price = P^A
• Number of firms = N^A

Question 13

Monopolistic competition: Trade (short run) Integration Under Trade

Answer 13

• Market demand doubles to 2D, and the number of firms becomes 2N^A
• Demand per firm remains constant 2D/2N^A = D/N^A

Question 14

Monopolistic competition: Trade (short run) Impact

Answer 14

• More firms in the market make demand for each firm more elastic

Question 15

Monopolistic competition: Short run free trade equilibrium Graph

Answer 15

• Market expansion through trade makes demand more elastic, flattening the demand curve (from d1 to d2).
• Marginal revenue also flattens moving it from MR1 to MR2
• this incentivises firms to produce at Q2 where MR2 = MC as they would earn monopoly profits here as P2 > AC
• Point B is unattainable however as all firms lower their pricing to p2 to ensure demand,
• The market moves to point B’, where average cost (AC) exceeds price (P). as the frims’ production has reduced to Q2’
• all firms run at a loss

Question 16

Monopolistic competition: Long-Run Free-Trade Equilibrium (summary)

Answer 16

• Firms experiencing losses will exit the market.
• Firm exit increases demand for remaining firms and reduces product variety for consumers.
• The integrated market will now have 2N^T firms
• which is less than the total of firms prior to trade 2N^A
• thus the demand facing the remaining firms is > prior to trade (D/N^T > D/N^A).

Question 17

Monopolistic competition: Long-Run Free-Trade Equilibrium (Graph)

Answer 17

• In the long-run equilibrium, the remaining number of firms (N^T) aligns with average industry demand (D/N^T) being sufficient to sustain them.
• The equilibrium is reached at point C, where the demand curve and average cost (AC) meet.
• price = average cost so profit = zero

Question 18

No trade (Autarky) vs Trade

Answer 18

Question 19

Gains from trade for consumers

Answer 19

• Price is lower
  (surviving firms produce more as they have more demand, drives down their cost of production, thus their selling price is reduced)
• an increase in variety
  (Trade increases variety as consumers access products from both countries despite fewer domestic varieties.)

Question 20

Adjustment costs from trade ( losses)

Answer 20

• Some firms shut down or exit the industry
• may lead to unemploymetn
• in the long run, we would expect the workers to find new jobs, so these costs are temporary