Monopolistic Competition

1. Imperfect competition

 Imperfect comeptition

The spectrum of business enterprise ranges from perfectly competitive firms to monopoly. Between these two extremes lies the business landscape in which the vast majority of firms actually operate.

Imperfect competition is a market structure with more than one firm in an industry in which at least one firm is a price setter.

An imperfectly competitive firm has some monopoly power. This power depends on product differentiation that leads to a downward sloping demand curve, or it may result from the interaction of rival firms in an industry with only a few firms. There are two broad categories of imperfectly competitive markets: oligopoly and monopolistic competition.

 monopolistic comeptition MP has some features that resemble competitive markets. In other respects, they also have the characteristics of monopolies. 
 Assumptions 1. A large number of firms.
2. Sellers are price makers
(sellers have downward sloping firm-specific demand curves.
3. Sellers do not behave strategically (as in monopoly or perfect competition).
4. free entry
5. products are differentiated, unlike perfect competition
(close substitutes). They are not a bunch of monopolists selling different goods.

This differentiation may occur by virtue of advertising, convenience of location, product quality, etc.
6. Buyers are price takers.


 The restaurant industry.

In most areas, there are many firms, each is different, and entry is easy. Each product has many close substitutes, including other restaurants, fast-food outlets, and the deli and frozen food at local supermarkets.


1. Which of the following markets are perfectly competitive or monopolistically competitive. Why?
a. soy market
b. retail clothing stores
c. Spago’s Restaurant Beverly Hills

Answer: The market for soybeans is perfectly competitive, as large numbers of buyers and sellers trade standardized products on a world market. Retail clothing and restaurants offer differentiated products and services, and are therefore monopolistically competitive.

  2. List three ways in which a grocery store might differentiate itself from its competitors.
Answer: A grocery store can differentiate itself from its competitors in many ways, including location, service, the quality of products and services offered, credit terms, and image.
   4. If Frank’s hot dog stand was profitable when he first opened, why should he expect those profits to fall over time?

Answer: If Frank earns significant profits when he first opened, he can expect to face competition in the future. Barriers to entry in the hot dog vending business are likely insignificant. New competitors are likely to enter the industry until economic profits are dissipated in the long run.

12. How does Starbucks differentiate its product? Why does Starbucks stay open until late at night but a donut or bagel shop might close at noon?

Answer: Starbucks differentiates its product by location, hours of operation, service, and quality of products. Starbucks is generally open late at night when many people desire to drink coffee because of its caffeine stimulant. People who generally opt for donuts and bagels in the morning will drink coffee throughout the day.

  16. Product differentiation is a hallmark of monopolistic competition, and the text lists four sources of such differentiation: physical differences, prestige, location, and service. How do firms in the industries listed here differentiate their products? How important is each of the four sources of differentiation in each case? Give the most important source of differentiation in each case.
a. fast-food restaurants
Answer: Physical differences are probably most important. Big Macs, Whoppers, tacos, and various sources of pizza all rely on physical differences to attract customers. Location of restaurants is important as well.
b. espresso shops/carts
Answer: A convenient location is very important, although service is considered an important aspect by many espresso drinkers.
c. hair stylists
Answer: Service is number one, but location is important as well. How far are you willing to drive to get a great cut or highlight?
d. soft drinks
Answer: Physical qualities, including taste and the look of the container, are most important, although location is important, too. Coca-Cola gained market leadership years ago by making Coke available everywhere—at movie theaters, at lunch counters, and in ubiquitous vending machines.
e. wine
Answer: Physical differences is probably the most important, but prestige is important as well.


2. Short Run

 SR problem choose q to maximize its profit 

 π = pd(p) - c(q),

where d(p) is SR demand curve.

d(p) is based on the assumption that other monopostically competitive firms set prices independently.

Each firm's market share is 1/N.

Sometimes this is called the proportional demand curve (SR demand curve).

First order condition  π' = MR - c'(q) = 0. 
 SR profit


Short Run: Not in the sense that capital is a fixed input, but in the sense that the number of firms is fixed.

In the SR, a monopolistically competitive firm can earn positive economic profits, as shown by the red tinted area. However, in the LR, free entry ensures that economic profits vanish.


3. Entry and LR equilibrium

 Effect of entry

 Market demand is given by

Q = D(p).

Each firm has a small share of the market. The proportional demand curve facing a typical firm is

q = D(p)/n,

where n is the number of monpolistically competitive firms.


If the market demand is given by

Q = 100 - 10p, 


 then the slope of the market demand curve is

dQ/dp = - 10.

If there are 20 firms in the market, the proportional demand curve in Long Run equilibrium is

q*(p) = D(p)/n = 5 - 0.5p,

and the slope of the proportional demand curve is

dq*/dp = -0.5.

 entry and exit

If the typical firm earns positive profits, the number of firms increases.

The proportional demand curve q = D(p)/n shrinks, rotating q(p) clockwise, as show below.

If the typical firm incurs a loss, firms exit and the proportional demand curve rotates counterclockwise. 

 LR equilibrium The number of firms increases or decreases until the typical firm earns zero profit. 
excess capacity

Ideal output is that output which is associated with the minimum point of the LAC curve.

A monopolistically competitive firm does not operate there in LR equilibrium.

Chamberlain argued for treating the higher production cost due to excess capacity as a social loss.

However, product differentiation is socially desirable.



4. Advertising

 Brand management Once a firm survives in a market by differentiating its product from competitors, it must maintain that differentiation through brand management


Advertising is an attempt to shift the firm's demand curve to the right.

How do consumers know your product differs from those of competitors? (i) by consumption or experience, (ii) advertising.

Samples are often given free to introduce goods to consumers.

Advertising is used to (i) introduce the product to new consumers (the consuming population is not stationary), and (ii) to remind consumers that one's brand is better than other competing products. 

Even familiar brands such as MacDonald's and Coke continue to advertise their products, because consumer population is not stationary. Consumers need to be informed, educated or assured each year.

Defending a Brand Name 

To protect one's Brand name, a company can apply for a trademark.

Trademark grants legal protection to prevent others from using the brand. If another firm uses the same brand, the firm loses loyal consumers. 

 Generic trademark

Also known as genericized trademark.

A brand becomes so popular that it becomes synonymous with a general class of product or service.

A trademark becomes genericized when it begins to be perceived by the public as the generic class of product or service, rather than a unique brand. This occurs especially, when the name is suggestive of its nature or discriptive.

Court in the US ruled that when genericization occurs a firm is no longer entitled to legal protection of the brand name. Examples: aspirin, escalator, thermos were originally all brand names.

(American patent of aspirin expired in 1917.) The popularity of aspirint declined after the market released competing brands: acetaminophen (e.g., Tylenol) in 1956 and ibuprofen (e.g. marketed as Advil) in 1969.

  14. Why is advertising more important for the success of chains such as Toys “R” Us and Office Depot than for the corner barber shop?
Answer: The corner barber shop services clients in a limited area. Many people are aware of the barbershop because it is local and they patronize local barbershops for the sake of convenience. Advertising is unlikely to attract a significant number of people from a different part of town to a particular barber shop. Toys R Us and Office Depot, on the other hand, which offer a large variety of products, are national chain stores which stand to benefit much more from advertising. Advertising may significantly increase the customer base of Toys R Us and Office Depot by attracting people who do not live in the vicinity of their stores.
In the 1950s, N.W. Ayer started ad campaign.

"A Diamond is forever"

"Is two months' salary a small price to pay for something that lasts forever?"

"A girl is not engaged unless she has a diamond engagement ring."

 Not a good investment

Gold/silver bullions/coins lose 10%.

Jewelry loses 2/3 of the value when sold.