CH11 MARKET POWER: PERFECT COMPETITION AND MONOPOLISTIC COMPETITION

Pages 185-190

Outline 11.4
I. What is the imperfect competition?
A. A market is considered to be imperfect if it fails to equate marginal social
cost (MSC) and marginal social benefit (MSB).
1. This applies to all markets where the firms face a normal,
downward-sloping demand curve.
2. Monopolists and other imperfect markets may restrict output to
push up prices and maximize profits because they have market
power.
a) Because of this, they do not produce at the socially
efficient level of output.
(1) This is shown in Figure 11.13

B. Because profits are maximized where MC=MR, Q1 will be produced at a

price of P1, and the socially efficient level of output, Q*, is not reached.
1. There is therefore a loss of consumer surplus, shown by the
shaded dark blue triangle, and a loss of producer surplus, shown
by the shaded pale blue triangle.
2. This community surplus is not maximized and we have a situation
of market failure.
a) When community surplus falls from the maximum, we say
that there has been a welfare loss.
(1) This is because the units Q1-Q* are not produced,
even though the marginal social benefit is greater
than the marginal social cost.
(a) The welfare loss is shown by the
combination of the two triangles.
C. The more imperfect a market- ie the greater the market power available to
firms- the greater the market failure that needs to be addressed will be.
1. As we know, in perfect competition there is a theoretical market
failure.
2. However, we also know that perfect competition is a theoretical
market form that may not exist in the real world.

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 3. We need to look at the other market forms and try to assess the
levels of market power, market failure, and thus intervention
needed.
II. What are the assumptions of monopolistic competition?
A. The theory of monopolistic competition was developed by Edward
Chamberlin (1899-1967), an American economist.
1. Chamberlain was dissatisfied with the two extreme theories that
existed at the time, perfect competition and monopoly, so wanted
to devise something more realistic that would sit between both
existent theories.
a) In simple terms, a monopolistically competitive market is
one with many competing firms where each firm has a little
bit of market power.
(1) This is why we have the term monopolistic, as firms
have some ability to set their own prices.
(a) They are mini-monopolies.
B. The assumptions for the monopolistic competition are as follows:
1. The industry is made up of a fairly larger number of firms.
2. The firms are small, relative to the size of the industry.
a) This means that the actions of one firm are unlikely to have
a great effect on any of its competitors.
(1) The firms assume that they are able to act
independently of each other.
3. The firms all produce slightly differentiated products.
a) This means that it is possible for a consumer to tell one
firm’s product from another.
4. Firms are completely free to enter or leave the industry.
a) That is, there are no barriers to entry or exit.
C. The only difference from perfect competition is that in monopolistic
competition there is product differentiation.
1. Product differentiation exists when a good or service is perceived
to be different from other goods or services in some way.
a) Products may be differentiated by brand name, color,
appearance, packaging, design, quality of service, skill
levels, and many other methods.
(1) Examples of monopolistically competitive industries
are nail salons, car mechanics, plumbers, and
jewelers.

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 D. Although it may appear to be a small difference from the assumptions of
perfect competition, this leads to a markedly different market structure.
1. As the products are differentiated there will be some extent of
brand loyalty.
a) This means that some of the consumers will be loyal to the
product and continue to buy if the price goes up a little.
E. This brand loyalty means that producers have some element of
independence when they are deciding on the price.
1. They are, to an extent, price-makers, and so they face a
downward-sloping demand curve.
a) However, demand will be relatively elastic since there are
many, only slightly different substitutes.
F. The demand curve facing a monopolistically competitive firm is shown in
Figure 11.14.
G. The firm faces a downward-sloping demand curve with a marginal
revenue curve that is below it and producers so that it is maximizing
profits where MC=MR.
1. This means that the firm in Figure 11.14 will produce an output of
q and sell that output at the price of P.
III. How much market power exists in monopolistic competition?
A. As the individual firms in monopolistic competition will be price-makers,
since they face downward-sloping demand curves, this means that a firm
is able to raise prices, so long as they are prepared to accept a fairly large
fall in quantity demanded. (Demand is relatively elastic)
1. However, the firm has very little market power, since it is so small
relative to the size of the industry,
a) Hence, it cannot increase the industry price by reducing
output.
IV. How do firms in monopolistic competition maximize profits in the short run?
A. Just as perfect competition, it is possible for firms in monopolistic
competition to make abnormal profits in the short run.
1. This is shown in Figure 11.15.
B. In this case, the firm is maximizing profits by producing at the level of
output where MC=MR and the cost per unit (AC) of C is less than the
selling price of P.

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 1. There is an abnormal profit that is shown by the shaded area.
C. It is also possible that a firm in monopolistic competition may be making
losses in the short run and this is shown in Figure 11.6.
1. Once again, the firm is producing where MC=MR, but this time the
cost per unit, C, is above the price, P, and the number of losses is
shown by the shaded area.

V. What happens to short-run profits or losses in the long run in monopolistic

competition?
A. Whether firms are making abnormal profits or losses in the short run,
because of the freedom of entry and exit in the industry, there will be a
long-run equilibrium, where all of the firms in the industry are making
normal profits.
B. If the firms are making short-run abnormal profits, then other firms will be
attracted to the industry.
1. Since there are no barriers to entry it is possible for these firms to
join the industry.
a) As they enter, they will take business away from the
existing firms, whose demand curves will start to shift to
the left.
C. If the firms are making short-run losses, then some of the firms in the
industry will start to leave.
1. The firms that remain will find that their demand curves start to
shift to the right as they pick up trade from the leaving firms.
D. This analysis explains why is not uncommon to see similar shops or
services spring up in an area.
1. Imagine that a new sushi restaurant opens up in a district.

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 a) Soon, it is so popular that there is a line outside the door
every evening.
(1) Other catering entrepreneurs will be attracted to the
possibility of doing so well, and so it is likely that
another sushi restaurant will open up in the area.
(a) It may not happen immediately, but
eventually, this is likely to result in a fall in
demand for the original restaurant as some
of its customers will switch.
(b) If demand continues to be strong then even
more restaurants will open.
(i) Each restaurant will try to distinguish
itself from the others- perhaps by
staying open longer, offering a
Happy Hour, special theme nights,
or free children’s meals, to name just
a few possibilities.
(a) This product differentiation is
also known as non-price
competition.
E. Whatever the short-run situation, in the long run, the firms will end up in
the position shown in Figure 11.17, with all making normal profits.

1. The firms are maximizing profits by producing at the level of output

where MC=MR and, at that output, the cost per unit, C, is equal to
the price per unit, P.
a) Each firm is exactly covering its costs, including its
opportunity costs, and so there is no incentive for firms to
leave the industry.
(1) Firms outside the industry will not enter, since they
will be aware that their entrance would lead to
losses for everyone.
(2) Table 11.1 summarizes the characteristics of
monopolistic competition and illustrates how Italian
restaurants in a city might be considered to be

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 close to a monopolistic competition market
structure.

VI. How efficient are firms in monopolistic competition?

A. The productive efficiency is achieved at the level of output where a firm
produces at the lowest possible cost per unit, the point where the MC
curve cuts the AC curve.
B. Allocative efficiency is achieved at the level of output where the MC curve
cuts the AR curve: the socially optimum level of output.

C. Figure 11.18 shows the two possible short-run positions in monopolistic

competition and abnormal profits and losses.
1. We see that the firm produces at the level of output where profits
are maximized, q, as opposed to the productively efficient level of
output, q1, or the allocatively efficient level of output, q2.
2. In the long run, the situation is the same.
a) This is shown in Figure 11.19;
(1) The firm is again producing at the profit-maximizing
level of output, q, and not at the productively
efficient level of output, q1, or the allocatively
efficient level of output q2.

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VII. Is there a market failure that needs to be rectified in monopolistic competition?
A. Unlike perfect competition, where in the long run the firms are
profit-maximizer, productively efficient, and allocatively efficient firms in
the long run in monopolistic competition, although maximizing profits, are
neither productively nor allocatively efficient.
B. There is a small market failure since the firms are not allocatively efficient.
1. This is shown in Figure 11.20 in the shaded area.
C. However, even though the firm in monopolistic competition is not
allocatively efficient, because it does not produce where MC=AR, the
inefficiency is not due to the firm’s ability to restrict output and increase
the price.
1. The inefficiency is, in fact, the result of the consumers’ desires for
variety,
a) Though allocative efficiency does not occur, it is hard to
argue that consumers are worse off with monopolistic
competition than with perfect competition, since the
difference is due entirely to consumer desire to have
differentiated products.
D. Rather than having a perfectly competitive situation, where consumers
would in theory pay lower prices but are only available to purchase a
homogenous product, the monopolistic competition gives consumers the
opportunity to make choices.

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 1. This is why they are prepared to pay slightly higher prices for the
products.
E. Because of the very small level of market power found in monopolistic
competition, governments do not intervene in these markets to curb that
power.
1. We should remember that they may try to correct other markets’
failures.
a) For example, they may try to correct imperfect information
by setting standards for trades, such as plumbers, and
then giving authorization to people who reach those
standards.
(1) In this way, consumers will be able to get
information on which firms are approved, reducing
previous imperfect information.

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