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Assumptions of the Monopolistic Competition Model
• Free entry and exit in the long run No barriers to entry
• Many firms, each one small relative to the size of the market Firms will have limited market power.
• Each firm produces a differentiated product Consumers view the goods as close substitutes,
but not perfect substitutes.
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Short-Run Profit Maximization for the Monopolistic Competitor
• Product differentiation creates a small amount of market power due to customer loyalty. Even if the firm raises its price, it will still retain
some of its customers.
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Economic Efficiency
• Is a monopolistic competitive industry Allocatively efficient? Productively efficient? Technologically efficient?
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Loss Minimization and the Shut-Down Point
• If demand decreases or costs increase, profits will fall. If the demand curve just touches the ATC curve
at the profit-maximizing level of output, the firm will earn normal economic profits.
If the demand curve just touches the AVC curve at the profit-maximizing level of output, the firm will be indifferent between operating and shutting down.
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Figure 11.4 Minimizing Losses and Reaching the Shutdown Point
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Monopolistic Competition in the Long Run
• In the short run, monopolistically competitive firms behave much like a monopolist.
• In the long run, however, monopolistic competition differs from monopoly because of free entry into the market.
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Firm Entry in Monopolistic Competition
• If firms in a monopolistically competitive market are earning positive economic profits, then new firms will enter the market. Similar to perfect competition
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Figure 11.5 Effects of New Entrants on the Demand for Cheesesteaks at John’s Roast Pork
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Firm Entry in Monopolistic Competition
• An important difference between monopolistic competition and perfect competition is that price does not fall to the minimum point on the long-run average cost curve. The firms are not efficient.
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Summary of Monopolistic Competition
• Each firm maximizes profits by producing the output for which MR = MC. Price is determined by the demand curve.
• Long-run entry implies that firms will be driven towards zero economic profits in the long run. P = LAC
• Price will be greater than the minimum point of LAC.
• Firms have different demand and costs, leading to long-run turnover of firms.
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Allocative Efficiency
• For monopolistically competitive firms, the profit-maximizing level of output is less than that which minimizes LAC. Monopolistically competitive firms are not
as efficient as perfectly competitive firms.
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Figure 11.6 The Long-Run Monopolistic Competition Equilibrium Versus the Perfect Competition Equilibrium
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Excess Capacity
• As a result of underproduction at both the firm and industry level, monopolistically competitive firms are said to exhibit excess capacity. Output could be increased without any
firms earning losses.
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The Benefits of Variety
• Is the reduction in efficiency associated with monopolistic competition bad for society?
• Not necessarily: Because consumers value variety, the
benefits of product differentiation may offset the costs of excess capacity.
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Table 11.1 Summary of Market Structure Characteristics for Perfect Competition, Monopolistic Competition, and Monopoly
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Advertising: Information or Persuasion?
• Unlike perfectly competitive firms or monopolists, monopolistically competitive firms will advertise to inform customers about their product.
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Brand Identity and Brand Loyalty
• The goal of advertising is to create: Brand Identity—the consumer’s ability to
recognize a product and associate it with a specific name.
Brand Loyalty—a consumer’s willingness to remain with a specific product despite the existence of competing products.• Makes demand less elastic
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Types of Advertising
• Informational—increases consumers’ knowledge of important product characteristics and price.
• Persuasive—attempts to alter consumer tastes and preferences by using subjective information.
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Summary (cont’d)
• In the long run, because of free entry and exit, monopolistically competitive firms will earn zero economic profits.
• Monopolistically competitive firms are less efficient than perfectly competitive firms. Excess capacity
• Product differentiation offsets some of the loss of efficiency.