Download Monopolistic Competition: Market Power and Product Differentiation and more Summaries Marketing in PDF only on Docsity!
5.2 Monopolistic Competition
Monopolistic competition is a market structure defined by free entry and exit, like competition, and differentiated products, like monopoly. Differentiated products provide each firm with some market power. Advertising and marketing of each individual product provide uniqueness that causes the demand curve of each good to be downward sloping. Free entry indicates that each firm competes with other firms and profits are equal to zero on long run equilibrium. If a monopolistically competitive firm is earning positive economic profits, entry will occur until economic profits are equal to zero.
5.2.1 Monopolistic Competition in the Short and Long Runs
The demand curve of a monopolistically competitive firm is downward sloping, indicating that the firm has a degree of market power. Market power derives from product differentiation, since each firm produces a different product. Each good has many close substitutes, so market power is limited: if the price is increased too much, consumers will shift to competitors’ products.
Figure 5.3 Monopolistic Competition in the Short Run and Long Run
Short and long run equilibria for the monopolistically competitive firm are shown in Figure 5.3. The demand curve facing the firm is downward sloping, but relatively elastic due to the availability of close substitutes. The short run equilibrium appears in
π
MR
P Crest (USD/oz)
PLR
ACSR
PSR
qSR qLR
P Crest (USD/oz)
q Crest (mil oz)
MC
ATC
SHORT RUN EQUILIBRIUM (^) LONG RUN EQUIILIBRIUM
D MR
q Crest (mil oz)
ATC
D
MC
the left hand panel, and is nearly identical to the monopoly graph. The only difference is that for a monopolistically competitive firm, the demand is relatively elastic, or flat. Otherwise, the short run profit-maximizing solution is the same as a monopoly. The firm sets marginal revenue equal to marginal cost, produces output level q*SR and charges price PSR. The profit level is shown by the shaded rectangle π.
The long run equilibrium is shown in the right hand panel. Entry of other firms occurs until profits are equal to zero; total revenues are equal to total costs. Thus, the demand curve is tangent to the average cost curve at the optimal long run quantity, qLR. The long run profit-maximizing quantity is found where marginal revenue equals marginal cost, which also occurs at qLR.
5.2.2 Economic Efficiency and Monopolistic Competition
There are two sources of inefficiency in monopolistic competition. First, dead weight loss due to monopoly power: price is higher than marginal cost. Second, excess capacity: the equilibrium quantity is smaller than the lowest cost quantity at the minimum point on the average cost curve. These two sources of inefficiency can be seen in Figure 5.4.
Figure 5.4 Comparison of Efficiency for Competition and Monopolistic Competition
First, there is dead weight loss (DWL) due to market power: the price is higher than marginal cost in long run equilibrium. In the right hand panel of Figure 5.4, the price at the long run equilibrium quantity is PLR, and marginal cost is lower: PLR > MC. This
qminAC
DWL
P Crest (USD/oz)
PLR
ACSR
PSR
q* (^) q^ q*LR
MC
ATC
COMPETITIVE FIRM
q Crest (mil oz)
P Crest (USD/oz)
D
ATC
MR
D
MC
LONG RUN EQUIILIBRIUM
