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Economics 2

Lecture 23: Monopolistic Competition

characteristics of monopolistic competition
inefficiency of monopolistic competition

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Characteristics of Monopolistic Competition

1. many buyers and sellers
2. slightly different products
3. free entry and exit
4. perfect information

In a monopolistically competitive market, firms use product differentiation more than price to compete. Toothpaste is basically toothpaste, but consumers are convinced that Crest toothpaste is different than Aim toothpaste. So, the makers of Crest have a monopoly in the market for Crest while the makers of Aim have a monopoly in the market for Aim. In the short run, monopolistic competitors can earn economic profits. They produce the quantity of output at which MR = MC.

Entry into the market causes the demand curve for all other competitor's products to decrease. New products are introduced as long as economic profits are positive. In the long run, free entry and exit allows only for normal profits.

Inefficiency of Monopolistic Competition

In monopolistic competition: too little of the good is produced the price is too high average costs are too high

The inefficiency of monopolistic competition results from consumer preferences for product differentiation. Product differentiation results in the demand curve facing the firm being downward sloping. Product differentiation can result from style, quality, and location. Advertising is used extensively to advise consumers of product differences. Product differentiation reduces the price elasticity of demand because of brand loyalty. Differentiation can allow firms to raise prices and profits although profits may not rise because of higher costs.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31