Economics Today

A Canadian Perspective Microeconomics, First Edition

Chapter 11
Monopolistic Competition

Copyright © 2023 Pearson Canada Inc. 11 - 1

Introduction
• Today, the fastest growing and one of the most
important means of delivering ads to intended
audiences is digital advertising via the Internet and
other communication networks.
• In this chapter, you will find out the economic
explanation for advertising, and what accounts for the
recent shift to advertising transmitted in digital
formats.

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Learning Objectives (1 of 2)
11.1 Discuss the key characteristics of a
monopolistically competitive industry
11.2 Contrast the output and pricing decisions of
monopolistically competitive firms with those of
perfectly competitive firms

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Learning Objectives (2 of 2)
11.3 Explain why brand names and advertising are
important features of monopolistically competitive
industries
11.4 Describe the fundamental properties of information
products and evaluate how the prices of these
products are determined under monopolistic
competition

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Chapter Outline
11.1 Defining Monopolistic Competition
11.2 Price and Output for the Monopolistic Competitor
11.3 Brand Names and Advertising
11.4 Information Products and Monopolistic Competition

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Did You Know That …
• there are more than 130,000 real estate brokerage
firms, agents, and salespeople in Canada? Most of
these brokerages and agents advertise services they
seek to differentiate from those provided by
competitors
• Product heterogeneity—variations in product
characteristics—and advertising did not show up in
our analysis of perfect competition. This situation has
been described as monopolistic competition, the
subject of this chapter.

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11.1 Defining Monopolistic Competition
(1 of 11)

• In the 1920s and 1930s, economists were aware of

industries that did not fit under perfect competition or
pure monopoly.
• Theoretical and empirical research were instituted to
develop some sort of middle ground.

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11.1 Defining Monopolistic Competition
(2 of 11)

• Two separately developed models of monopolistic

competition resulted.
• At Harvard, Edward Chamberlin published Theory of
Monopolistic Competition in 1933.
• That same year, Joan Robinson of Cambridge
published The Economics of Imperfect Competition.

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11.1 Defining Monopolistic Competition
(3 of 11)

• Monopolistic competition
– This is a market situation in which a large number of
firms produce similar but not identical products.
– Entry into the industry is relatively easy.

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11.1 Defining Monopolistic Competition
(4 of 11)

• Characteristics of monopolistic competition:

– Significant numbers of sellers in a highly competitive
market
– Differentiated products
– Sales promotion and advertising
– Easy entry of new firms in the long run

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11.1 Defining Monopolistic Competition
(5 of 11)

• Implications of the large number of firms:

– Small share of market
– Lack of collusion
– Independence

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11.1 Defining Monopolistic Competition
(6 of 11)

• Product differentiation
– The distinguishing of products by brand name, colour,
and other minor attributes

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11.1 Defining Monopolistic Competition
(7 of 11)

• Product differentiation and price:

– The firm has some control over the price it charges.
– Unlike a perfect competitor, the firm faces a downward-
sloping demand curve.
– Consider the abundance of brand names for many
products.
 The more successful the firm is at differentiation, the
more control it has over price.

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Example: A New Wave of Product Differentiation
Sweeps the Movie Theatre Industry
• Product differentiation is a fundamental characteristic
of the movie theatre industry.
• Today, many theatres offer wide varieties of food
offerings from items on movie-themed menus to
luxury dinners.
• Some theatres also have switched from traditional
seats to luxury recliners, replaced traditional film
screens with virtual-reality systems, and added child
play areas.

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11.1 Defining Monopolistic Competition
(8 of 11)

• What do you think about advertising?

– Would a perfect competitor have any incentive to
advertise?
– Why would a monopolistically competitive firm
advertise?
– Can advertising lead to efficiency?

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11.1 Defining Monopolistic Competition
(9 of 11)

• Sales promotion and advertising:

– Can increase demand for a firm
– Can differentiate a firm’s product
– Can result in increased profits

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11.1 Defining Monopolistic Competition
(10 of 11)

• Question:
– How much advertising should be undertaken?
• Answer:
– It should be carried to the point at which the additional
revenue from $1 more of advertising just equals that $1
of additional cost.

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11.1 Defining Monopolistic Competition
(11 of 11)

• Ease of entry:
– For any current monopolistic competitor, potential
competition is always lurking in the background.
– The easier—that is, the less costly—entry is, the more
a current competitor must worry about losing business.

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Behavioural Example: Why Physicians in
Norway Behave Differently While Working in
Second Jobs at Private Practices
• A number of physicians in Norway work in both
emergency centres and private medical practices.
• Research finds evidence that these physicians issue
about 10 percent more “sickness certificates” to patients
in the highly competitive private medical practices than
they issue to patients in emergency centres protected
from competition.
• Sickness certificates, which enable patients to justify
missed work time, function as a form of sales promotion
in monopolistically competitive private practices.

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11.2 Price and Output for the
Monopolistic Competitor (1 of 5)
• The individual firm’s demand and cost curves:
– The demand curve slopes downward.
– Profit is maximized where MC intersects MR from
below.

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11.2 Price and Output for the
Monopolistic Competitor (2 of 5)
• Short-run equilibrium:
– In the short run, it is possible for a monopolistic
competitor to make economic profits—profits over and
above the normal rate of return, or beyond what is
necessary to keep that firm in the industry.
– Losses in the short run are clearly also possible.

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11.2 Price and Output for the
Monopolistic Competitor (3 of 5)
• The long run—zero economic profits:
– The rate of return will tend toward normal.
– Economic profits will tend toward zero:
 So many firms produce substitutes that any economic
profits will disappear with competition.
 Economic profits are reduced to zero either through entry
of new firms seeking to earn a higher rate of return or by
changes in product quality and advertising outlays by
existing firms.

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Figure 11-1 Short-Run and Long-Run Equilibrium
with Monopolistic Competition, Panel (a)

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Figure 11-1 Short-Run and Long-Run Equilibrium
with Monopolistic Competition, Panel (b)

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Figure 11-1 Short-Run and Long-Run Equilibrium
with Monopolistic Competition, Panel (c)

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11.2 Price and Output for the
Monopolistic Competitor (4 of 5)
• Question:
– If both a monopolistic competitor and a perfect
competitor make zero economic profit in the long run,
how are they different?
• Answer:
– The demand curve for the individual perfect competitor
is perfectly elastic.
– The demand curve for the individual monopolistic
competitor is less than perfectly elastic

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Figure 11-2 Comparison of the Perfect Competitor
with the Monopolistic Competitor

In panel (a), the perfectly competitive firm has zero economic profits in the long run. The price is set equal
to marginal cost, and the price is P1. The firm’s demand curve is just tangent to the minimum point on its
average total cost curve. With the monopolistically competitive firm in panel (b), there are also zero
economic profits in the long run. The price is greater than marginal cost, though. The monopolistically
competitive firm does not find itself at the minimum point on its average total cost curve. It is operating at
a rate of output, q2, to the left of the minimum point on the ATC curve.

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11.2 Price and Output for the
Monopolistic Competitor (5 of 5)
• In perfect competition, the long-run equilibrium occurs
where average total cost is minimized. (This does not
occur in monopolistic competition.)
• Some have argued that this is not necessarily a waste
of resources as the added cost arises from product
differentiation.
• Chamberlin argued that it is rational for consumers to
have a taste for differentiation; consumers willingly
accept the resultant increased production costs in
return for more choice and variety of output.

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AI—Decision Making Through Data:
Analysis of Billions of Prices
• University of Chicago economists found evidence that
prices tended to be the same across stores owned by
the same retail-chain companies but in different areas.
• Instead, variations in prices of comparable products
mainly reflect differences in consumers’ preferences
for the retailers’ similar but distinguishable products.
• Thus, monopolistic competition involving differentiated
products accounts for most price variations.

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11.3 Brand Names and Advertising (1 of 7)
• Because “differentness” has value for consumers,
monopolistically competitive firms regard their brand
names as valuable private (intellectual) property.
– Firms use trademarks, words, symbols, and logos to
distinguish their product brands from goods or services
sold by other firms.
 A successful brand image contributes to a firm’s
profitability.

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11.3 Brand Names and Advertising (2 of 7)
• Brand names and trademarks:
– A company’s value in the marketplace depends largely
on current perceptions of future profitability.
– We can see it in the market value of the world’s most
valuable product brands.
– Valuation depends on the market prices of shares of
stock of a company times the number of shares traded.

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Table 11-1 Values of Firms with the Top Ten Brands

Brand Estimated Value ($ billions)

Amazon 315.5
Apple 309.5
Google 309.0
Microsoft 111.2
Visa 177.9
Facebook 159.0
Alibaba 131.2
Tencent 130.9
McDonald’s 130.4
AT&T 108.4
Source: Brand Z Most Valuable Brands Study, 2019.

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11.3 Brand Names and Advertising (3 of 7)
• Direct marketing
– Advertising targeted at specific consumers via postal
mailings, telephone calls, or e-mail messages
• Mass marketing
– Advertising intended to reach as many customers as
possible via TV, newspaper, radio, or magazine ads
• Interactive marketing
– Advertising that permits a consumer to follow up
directly by searching for more information

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11.3 Brand Names and Advertising (4 of 7)
• Search good
– A product with characteristics that enable an individual
to evaluate the product’s quality in advance of a
purchase
• Experience good
– A product that an individual must consume before the
product’s quality can be established
• Credence good
– A product with qualities that consumers lack the
expertise to assess without assistance

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11.3 Brand Names and Advertising (5 of 7)
• Examples of search goods:
– Clothing and music evaluated prior to purchase
• Examples of experience goods:
– Soft drinks, restaurants, and movies
• Examples of credence goods:
– Health care and legal advice

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11.3 Brand Names and Advertising (6 of 7)
• Informational advertising
– Advertising that emphasizes transmitting knowledge
about the features of a product
• Persuasive advertising
– Advertising that is intended to induce a consumer to
purchase a particular product and discover a previously
unknown taste for the item

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11.3 Brand Names and Advertising (7 of 7)
• Advertising as a signalling behaviour:
– Individual companies can explicitly engage in signalling
behaviour.
– They do so by establishing brand names or trademarks
and promoting them.

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11.4 Information Products and
Monopolistic Competition (1 of 5)
• Information products, such as digital devices, online
games, digital music and videos, educational and
training software, have a unique cost structure.
• Product development entails high fixed costs but is
distributed for sale at a relatively low marginal cost.

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11.4 Information Products and
Monopolistic Competition (2 of 5)
• Information product
– An item that is produced using information-intensive
inputs at a relatively high fixed cost but distributed for
sale at a relatively low marginal cost

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Figure 11-4 Cost Curves for a Producer of an
Information Product

The total fixed cost of producing an online game is $250,000. If the producer sells 5,000 copies,
average fixed cost falls to $50 per copy. If quantity sold rises to 50,000, average fixed cost decreases to
$5 per copy. Thus, the producer’s average fixed cost (AFC) curve slopes downward. If the per-unit cost of
delivering each copy of the game online is $2.50, then both the marginal cost (MC) and average variable
cost (AVC) curves are horizontal at $2.50 per copy. Adding the AFC and AVC curves yields the ATC curve.
Because the ATC curve slopes downward, the producer of this information product experiences short-run
economies of operation.

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11.4 Information Products and
Monopolistic Competition (3 of 5)
• Short-run economies of operation
– A distinguishing characteristic of an information product
arising from declining short-run average total cost as
more units of the product are sold

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11.4 Information Products and
Monopolistic Competition (4 of 5)
• Consider how online game manufacturers operate in a
monopolistically competitive market.
• In monopolistic competition, marginal cost pricing
results in losses for the firm, even though it creates
efficiencies for the economy as a whole.

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11.4 Information Products and
Monopolistic Competition (5 of 5)
• Providing an information product entails incurring relatively
high fixed costs but a relatively low per-unit cost for
additional units of output.
• The ATC for a firm that sells an information product slopes
downward, meaning the firm experiences short-run
economies of operation.
• In a long-run monopolistically competitive equilibrium, price
adjusts to equal ATC; the firm earns sufficient revenues to
cover total costs, including the opportunity cost of capital.
• Consumers thereby pay the lowest price necessary to
induce sellers to provide the item.

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Figure 11-5 The Infeasibility of Marginal Cost
Pricing of an Information Product

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What Happens When … an author who independently
sells an information product—a self-help e-book—
and initially earns zero economic profits experiences
a large increase in the demand for downloads of the
item?
• The author’s MR curve shifts rightward.
• Hence, MR will now equal MC at a larger profit-
maximizing quantity of e-books downloads.
• The new profit-maximizing price that buyers are willing
to pay will be determined along the new demand curve
at a level above the ATC of providing the larger quantity
of downloads.
• Consequently, the author will earn positive economic
profits.
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Economics in Your Life: A&W Turns to Beyond
Meat and Other Menu Changes to Differentiate
Their Food
• A&W introduced the first plant-based burger, the
Beyond Meat burger, which is made using 100
percent plant-based protein. The Beyond Meat burger
was extremely successful in targeting vegans and
vegetarians, while also appealing to environmentally
and health-conscious consumers.
• By differentiating their products from other popular
fast-food restaurants, A&W has created consumer
loyalty and trust. Customers are willing to pay a
premium for higher-quality fast food from A&W.

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Issues & Applications: Canadian Industries
That Differentiate Their Products via Digital
Advertising
• During the past decade, Canadian companies have
opted to increase the amount of advertising in digital
formats. Such ads typically appear on Internet sites
and social media pages and are distributed via email,
text, and other messages transmitted electronically by
firms to customers’ digital devices.
• Retail firms that are heavily involved in
monopolistically competitive product differentiation are
the top spenders on digital ads. A wide variety of
Canadian companies also spend heavily on digital
advertising in an effort to differentiate their products.
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Figure 11-6 Canadian Digital Ad Revenue by
Major Product Category

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Summary Discussion of Learning
Objectives (1 of 4)
11.1 Discuss the key characteristics of a
monopolistically competitive industry
– Large number of small firms
– Differentiated products
– Easy entry and exit
– Advertising and sales promotion

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Summary Discussion of Learning
Objectives (2 of 4)
11.2 Contrast the output and pricing decisions of
monopolistically competitive firms with those of
perfectly competitive firms
– A monopolistically competitive firm in the short run:
 Produces output to the point that MR = MC
 Can charge more than MC and ATC to earn economic
profits

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Summary Discussion of Learning
Objectives (3 of 4)
11.3 Contrast the output and pricing decisions of
monopolistically competitive firms with those of
perfectly competitive firms
– A monopolistically competitive firm in the long run:
 Price = ATC as firms enter the industry
 Like a perfectly competitive firm, earns zero economic
profits
 Price exceeds MC

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Summary Discussion of Learning
Objectives (4 of 4)
11.4 Explain why brand names and advertising are
important features of monopolistically competitive
industries
– They engage heavily in advertising and marketing.
11.5 Describe the fundamental properties of information
products and evaluate how the prices of these
products are determined under monopolistic
competition
– In the long run equilibrium, price adjusts to equality
with average total cost.

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