Why Markets Fail

• Market Power – Monopoly , Monopolistic Competition,

Oligopoly
• Externalities: market prices do not reflect the activities
of either producers or consumers
• Public Goods: market fails to supply goods that many
consumers value.

• Incomplete Information: lack of information may give

producers an incentive to supply too much of some products
and too little of others. In other cases, while some consumers
may not buy a product even though they would benefit from
doing so, others buy products that leave them worse off
 Monopoly

Number of Firms
Many
firms
Type of Products

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly Competition Competition

• Tap water • Tennis balls • Novels • Wheat

• Indian Railways • Crude oil • Movies • Milk

Copyright © 2004 South-Western

Concept of Double Marginalisation
– Q: What’s worse than one monopolist?
– A: Two monopolists
• Each firm then prices at a mark-up over
marginal cost.
• Recall that pricing above MC yields
deadweight losses
• Now these are being incurred twice!
• E.g. : Retailer and wholeseller are monopolies
 Monopolistic Competition
Number of Firms

Many
firms

Type of Products

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly Competition Competition

• Tap water • Tennis balls • Novels • Wheat

• Cable TV • Crude oil • Movies • Milk

Copyright © 2004 South-Western

 Monopolistic Competition
• Two key characteristics:
– Firms compete by selling differentiated products that are
highly substitutable for one another but not perfect
substitutes. In other words, the cross-price elasticities of
demand are large but not infinite.
– There is free entry and exit: it is relatively easy for new firms to
enter the market with their own brands and for existing firms to
leave if their products become unprofitable.

• Because the firm is the only producer of its brand, it faces a

downward-sloping demand curve.
• Price exceeds marginal cost and the firm has monopoly
power
 Market Entry and
Monopolistic Competition
• Firms enter an oligopolistic market in response to
profit opportunities
• Several factors affect the number of firms that enter:
– Fixed cost associated with becoming active in the market
• As the fixed cost shrinks and the number of firms grows, the
possible profits of an active firm approach zero
– Size of the market
– Intensity of competition
• Because profits are lower in a market with more intense
competition, fewer firms will enter

19-8
Factors Affecting the Number of Firms

19-9
 Product Differentiation and Monopolistic
Competition
• In markets with product differentiation firms must decide
what kind of good to produce
• Monopolistic competition is a market with:
– A large number of firms
– Each produces a unique product
– Prices above marginal cost
– Close to zero profit, net of fixed costs
• Firm’s demand curve is downward sloping due to
differentiation
• At the firm’s profit-maximizing price and quantity, P=AC so
the firm breaks even
• Entry in monopolistically competitive markets may be
excessive or insufficient relative to the level that maximizes
aggregate surplus
19-10
Monopolistic Competition

19-11
 Equilibrium in the Short Run and the Long Run
• Short run: price
exceeds average
cost, and the firm
earns profits
shown by the
yellow-shaded
rectangle

• Long run: these

profits attract new
firms with
competing brands.
The firm’s market
share falls,
demand curve
Short run Long run
shifts till P= AC
 Welfare Effects
• In both PC and Monopolistically Competitive markets, entry occurs until
profits are driven to zero.
• Under PC, P=MC. The demand curve facing the firm is horizontal, so the
zero-profit point occurs at the point of minimum AC
• Under monopolistic
competition,
P>MC.
• deadweight loss:
yellow-shaded
area.
• The demand curve
is downward-
sloping, so the
zero-profit point is Perfect competition Monopolistic competition
to the left of the
point of minimum In evaluating monopolistic competition, these
AC. inefficiencies must be balanced against the gains to
consumers from product diversity.