Week 7 - Monopolistic competition Flashcards
define monopolistic competition
Many firms selling products that are similar but not identical (falls between perfect competition and pure monopoly)
defining characteristics of monopolistic competition
- Many sellers
- Product differentiation (not homogenous)
- Free entry and exit
So many sellers that firms act independently and do not collude (artificial price not driven by forces of supply + demand)
Rather than being a price taker, each firm faces downward slopping demand curve
Differentiation creates market power, allowing low degree of ‘market power’ allowing price making
Firms can enter and exit without restriction into the market, the number of firms in the market adjusts until economic profits are zero
EXPLAIN monopolistic firms in the short run
For monopolistically competitive firms, short‐run economic profits encourage new firms to enter the market.
• This increases the number of products offered.
• This reduces demand faced by firms already in the
market.
• Incumbent firms’ demand curves shift to the left.
• Demand for the incumbent firms’ products fall, and their
profits decline.
Marginal revenue curve will not be horizontal because they hold some market power
For monopolistically competitive firms, short‐run economic losses encourage firms to exit the market. This:
• decreases the number of products offered
• increases demand faced by the remaining firms
• shifts the remaining firms’ demand curves to the right
• increases the remaining firms’ profits
explain and draw monopolistic competition profits in the long term
in the long run monopolistic firms make zero profits similar to perfect competition (*however in perfect competition ATC will be operating at the lowest point) therefore product differentiation leads to costs not being minimized
explain and draw the difference between perfect competition and monopolistic competitive firms
The long run equilibrium in a monopolistically competitive market differs that in a perfect market in 2 ways.
First each firm in a monopolistically competitive market has excess capacity. That is there it chooses a quantity that puts it on the downward sloping portion of the average total cost curve,
Secondly each firm charges a cost above marginal costs
Monopolistically competitive firms do not have desirable properties of perfect competition – there is a standard deadweight loss of monopoly caused by the mark up of price over marginal cost.
benefit and disadvantage of advertising
Critics argue that firms use advertising to take advantage of consumer irrationality and to reduce competition.
Critics of advertising argue that firms advertise in order to manipulate people’s tastes.
• They also argue that it impedes competition by implying that products are more different than they truly are.
Defenders argue advertising they inform consumers to compete more vigorously on price and product quality
- Defenders argue that advertising provides information to consumers
- They also argue that advertising increases competition by offering a greater variety of products and prices.
- The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.
The chapter states that a monopolistically competitive firm could in crease the quantity they produce and lower the average total cost of production. Why doesn’t it do so?
Monopolistically competitive firms do not increase the quantity they produce to lower the average cost of production because doing so would require them to lower their price enough that the marginal revenue would be below the marginal cost. As with monopolists, marginal revenue equals marginal cost at the optimal quantity ;for a monopolistically competitive firm, since price is greater than marginal revenue which equals
marginal cost, and since the firm earns zero economic profit price quals average total cost ,average total cost is greater than marginal cost – this implies that increasing output would reduce average total cost
2 major differences between perfect competition and monopolistic competition
There are two noteworthy differences between monopolistic and perfect competition
• HIGHER AVERAGE COSTS:
here is no excess capacity in perfect competition in the long
run.
–Free entry results in competitive firms producing at the point
where average total cost is minimized, which is the efficient scale of the firm.
Firms produce at higher average cost in monopolistic
competition in the long run.
–In monopolistic competition, output is less than the efficient
scale of perfect competition.
MARK UP
Markup = For a competitive firm, price equals marginal cost. –For a monopolistically competitive firm, price exceeds
marginal cost.
–Price > marginal cost: an extra unit sold at the posted price
means more profit for the monopolistically competitive fir
MONOPOLISTIC COMPETITION AND THE WELFARE OF SOCIETY
Mark‐up of price over marginal cost causes deadweight loss of monopoly
• Regulating pricing of these firms administratively prohibitive
– costs of regulating firms with differentiated products exceeds
the benefits
Socially inefficient: number of firms in the market may not be the ‘ideal’ one. There may be too much or too little entry
Externalities of entry include:
– product‐variety externalities – business‐stealing externalities
The product‐variety externality:
The product‐variety externality:
–Because consumers get some consumer surplus from the
introduction of a new product, entry of a new firm conveys a positive externality on consumers.
The business‐stealing externality:
The business‐stealing externality:
–Because other firms lose customers and profits from the entry
of a new competitor, entry of a new firm imposes a negative externality on existing firms.
Howis monopolistic competition like monopoly? How is it likeperfect competition?
Monopolistic competition is like monopoly because firms face a downward-slopingdemand curve, so price exceeds marginal cost. Firms in Monopolistic Competition have some market power and hence some ability to set price. But this is not a full control of prices. If they increase price too much, they may find that demand collapses - they are still constrained by the demand for their product. Monopolistic competition is likeperfect competition because, in the long run, price equals average total cost, as freeentry and exit drive economic profit to zero. There are many buyers and sellers, but each firm’s product is slightly different, not identical as it is in perfect competition
How might advertising reduce economic wellbeing? How might advertising increase economic wellbeing?
Advertising might reduce economic wellbeing because it is costly, manipulates people’s tastes, and impedes competition by making products appear more different than ethereally are. But advertising might increase economic wellbeing by providinguseful information to consumers and fostering competition because it allowsconsumers to be better informed about all of the firms in the market.Advertising also serves as a signal of quality. The willingness of a firm to spend a large amount of money on advertising may be a signal to consumers about the quality of the product being offered.
