LEAD 731 Lecture Notes - Lecture 20: Monopolistic Competition, Creative Destruction, Fixed Cost
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How to Study for Chapter 20 Monopolistic Competition
Chapter 20 introduces the tools for analyzing the behaviors of companies in monopolistic
competition.
1. Begin by looking over the Objectives listed below. This will tell you the main points you
should be looking for as you read the chapter.
2. New words or definitions and certain key points are highlighted in italics and in red color.
Other key points are highlighted in bold type and in blue color.
3. You will be given an In Class Assignment and a Homework assignment to illustrate the main
concepts of this chapter.
4. There are a few new words in this chapter. Be sure to spend time on the various definitions.
Go over the graphs very carefully. They will be very important throughout the remainder of
the course.
5. The teacher will focus on the main technical parts of this chapter. You are responsible for
the cases and the ways by which each case illustrates a main principle.
6. When you have finished the text, the Test Your Understanding questions, and the
assignments, go back to the Objectives. See if you can answer the questions without looking
back at the text. If not, go back and re-read that part of the text. When you are ready, take
the Practice Quiz for Chapter 20.
Objectives for Chapter 20 Monopolistic Competition
At the end of Chapter 20, you will be able to answer the following:
1. Explain how a company in monopolistic competition would determine the profit-
maximizing quantity and price.
2. Show the graph for a company in monopolistic competition
3. Explain what will result in monopolistic competition if a company is earning economic
profits. Show this on the graph.
4. Explain what will result in monopolistic competition if a company is earning economic
profits. Show this on the graph.
5. Explain what will happen to a company in monopolistic competition if there is a decrease in
demand for the product. Apply this analysis to the case of movie theaters.
6. Explain what will happen to a company in monopolistic competition if there is a decrease in
a fixed cost of production or a variable cost of production. Apply this analysis to the case
of movie theaters.
7. Compare the performance of monopolistically competitive and purely competitive industries.
Why do monopolistically competitive companies have "excess capacity" in the long-run?
8. Explain what is meant by “creative destruction”.
9. Using the computer industry as an example, explain both how monopolistically competitive
companies operate and also the process of “creative destruction”.
10. What is an “experience good”? How is it marketed differently than other goods?
Chapter 20 Monopolistic Competition (latest revision July 2004)
In Chapter 16, monopolistic competition was defined as an industry with one seller (i.e., a
monopoly) of a very narrowly defined product. The demand for this product is very elastic
because there are many close substitutes for it. The close substitutes provide the competition.
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Examples given included Coca Cola, McDonalds, and personal computers. In essence,
monopolistic competition has four main characteristics:
1. One seller of a narrowly defined product (such as Diet Coke)
2. Many close substitute products --- the products of the competitors are
differentiated
3. Good information on the part of buyers and sellers
4. Relatively easy entry and exit from the industry.
Monopolistic competition is the way that most actual competition occurs. In most cases
where there is sufficient competition, the products of the various competitors are
differentiated. Supermarkets sell dozens of brands of cereal, ice cream or frozen yogurt, soaps,
toothpaste, and so forth. Companies spend billions of dollars in advertising, trying to
differentiate their products from those of their competitors. There are several reasons that this
product differentiation is so common. First, and most obvious, is the fact that the tastes of
different people are different. In some cases (for example aspirin), there are no actual
differences between the products. But people perceive that there are real differences. For
example, one coffee company ran a series of commercials showing that customers in fancy
restaurants could not tell the difference between their instant coffee and fresh coffee. Yet, most
buyers still prefer the fresh coffee to instant coffee. Some prefer coffee strong while others
prefer it weaker. Some prefer it sweeter while others dislike sweet coffee. Companies try to
produce for all of these different preferences. Second, there are differences in income that
cause people to buy different goods and services. For this reason, sellers will sell color
television sets that range in price from $300 to several thousands of dollars. And the Honda
Motor Company produces Civics, Accords, and the Acuras.
Decision Making with Monopolistic Competition
Let us examine the graph for a company in a monopolistically competitive industry as shown
on the next page. Notice that the demand for the company’s product is very elastic (flat).But it
is not horizontal. For example, Coca Cola can raise its price above its competitors’ prices and
still be able to sell Coca Cola. However, if it raises its prices very much, the quantity it sells
could fall dramatically. Because an increase in price causes the quantity demanded to fall, the
demand curve is downward-sloping. And as we saw in Chapter 18, since the demand curve is
downward-sloping, the marginal revenue must be below the demand curve. This is the
same situation as in any “monopoly” --- that is, in any situation in which the company has some
ability to affect its price. The only difference between the demand curve facing a seller in
monopolistic competition and the demand curve facing the seller in pure monopoly is that the
demand curve for monopolistic competition is very elastic (because there are many substitute
goods). The goal of the company is to maximize profits. We know that this occurs where the
marginal revenue equals the marginal cost (point a). The company produces quantity Q1.
Going up from point a to the demand curve (point b) shows that the price is P1. Finally, we
calculate the profits as (price minus average total cost) times the quantity --- the rectangle
bcde. There is no industry supply curve here. Each company must be considered separately.
There is no way to add up hamburgers, pizzas, and tacos.
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Monopolistic Competition with Economic Profits
$
Marginal Cost
Average Total Cost
e b
Demand1
d f c
a Demand2
Marginal Revenue2
Marginal Revenue1
0 Q2Q1 Quantity
Explanation. Since the demand is downward-sloping, the marginal revenue is below the demand
curve. This is the same situation as in any “monopoly” --- that is, in any situation in which the
company has some ability to affect its price. The goal of the company is to maximize profits. This
occurs where the marginal revenue equals the marginal cost (point a). The company produces
quantity Q1. Going up from point a to the demand curve (point b) shows that the price is P1. Finally,
we calculate the profits as (price minus average total cost) times quantity --- the rectangle bcde. In
the long run, competing companies would enter. The company would perceive that new competitors
were taking away its business. The demand for its product would fall (shift left). As it did, the
economic profits would fall. When the economic profits fell to zero, there would be no reason for
new competitors to enter. The situation is called “long-run equilibrium” (point f)
Document Summary
How to study for chapter 20 monopolistic competition. Chapter 20 introduces the tools for analyzing the behaviors of companies in monopolistic competition: begin by looking over the objectives listed below. This will tell you the main points you should be looking for as you read the chapter: new words or definitions and certain key points are highlighted in italics and in red color. Be sure to spend time on the various definitions. They will be very important throughout the remainder of the course: the teacher will focus on the main technical parts of this chapter. You are responsible for the cases and the ways by which each case illustrates a main principle: when you have finished the text, the test your understanding questions, and the assignments, go back to the objectives. See if you can answer the questions without looking back at the text. If not, go back and re-read that part of the text.
