1 C H A P T E R 11 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Entry and Monopolistic Competition

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© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Entry and Monopolistic Competition

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The Effects of Market Entry

In the absence of substantial economies of scale, it is possible for additional firms to enter the market, driving down prices and profit.

Output decisions are based on the marginal principle:

Marginal PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

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When a second firm enters the market, the monopoly’s demand and marginal revenue curves shift inward.

The firm’s price and output level will have to be adjusted in order to follow the marginal principle.

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Given the structures of cost and revenue, the monopoly satisfies the marginal principle by producing and selling 300 toothbrushes at $2 each.

After entry, each of two firms produces 200 units and charges $1.85 per unit.

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Before entry, the monopoly produces 300 units, at a cost per unit of $0.90 per toothbrush.

After entry, each of two firms produces 200 units at an average cost of $1.00.

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There are three reasons why profit decreases for the individual firm after entry of a second firm:

Lower price

Lower quantity sold

Higher average cost of production

Summary:

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Characteristics of Monopolistic Competition

Characteristics of Monopolistic Competition:

Many firms

Differentiated product

No artificial barriers to entry

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The Meaning of “Monopolistic Competition”

Each firm is monopolistic because it sells a unique product.

The availability of close substitutes makes the firm’s demand very price elastic.

Each firm is a competitive because it sells a product that is a close but not a perfect substitute for the products sold by other firms in the market.

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Product Differentiation

Physical characteristics

Location

Services

Aura or image

Firms may differentiate their product in several ways:

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Short-run and Long-run Equilibrium Under Monopolistic Competition

As firms enter, each firm’s demand curve shifts to the left, decreasing market price, decreasing the quantity produced per firm, and increasing the average cost of production.

As long as there is profit to be made, more and more firms will enter the market.

Entry will stop once the economic profit of each existing firm reaches zero. In the long run, revenue will be just enough to cover all costs, including the opportunity cost of all inputs, but not enough to cause additional firms to enter.

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Long-run Equilibrium Under Monopolistic Competition

In this example, the marginal principle is satisfied at 55 thousand toothbrushes per minute, selling at a price of $1.35. The cost of producing each toothbrush is also $1.35. Economic profit equals zero.

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Trade-offs with Monopolistic Competition

Monopoly Monopolistic Competition

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Trade-offs with Monopolistic Competition

Monopolistic competition brings good news and bad news relative to the monopoly outcome:

Good news: lower price and greater variety

Bad news: higher average cost

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Spatial Differentiation and Competition

There are many spatially differentiated products. When firms differentiate their products by offering them at more locations, the benefit of having more firms is that consumers travel shorter distances to get the product.

With a single seller, the average cost of production would be lower, but prices would be higher, and consumers would spend more time traveling to buy the product.

Documents

1 C H A P T E R 11 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Entry and Monopolistic Competition