26.1 The Effects of Market Entry

• Monopolistic competition is a market served by many firms that sell slightly different products.

• A firm’s profit is expressed as:

  • Profit = (price - average cost) X quantity

• To illustrate the effects of entry on price, cost, and profit, imagine that you just inherited enough money to start your own car-stereo business.

  • Suppose that the existing monopolist sells 10 stereos per day at a price of $230 and an average cost of $200 per stereo, for a profit of $30 per stereo.

  • If you enter the market, the increased competition will drop the price below $230, and if you sell fewer than 10 stereos (the monopoly quantity), your average will be greater than $200 because you will spread your fixed costs over fewer units.

  • In other words, your entry squeezes profit per unit from both sides.

26.2 Monopolistic Competition

• Under a market structure called monopolistic competition, firms will continue to enter the market until economic profit is zero.

• The features of monopolistic competition are:

  • Many firms, because there are relatively small economies of scale, a small firm can produce its product at about the same average cost as a large firm.

  • A differential product, firms engage in product differentiation, the process used by firms to distinguish their products from the products of competing firms. A firm can distinguish its products from the other products of other firms by offering a different performance level or appearance. Some products are differentiated by the services that come with them.

  • No artificial barriers to entry, there are no patents or regulations that could prevent firms from entering the market.

• An increase in price decreases the quantity demanded by a relatively large amount because consumers can easily switch to another firm selling a similar product.

26.3 Trade-Offs with Entry and Monopolistic Competition

• Market entry leads to lower prices and larger total quantities in the market. At the same time, entry decreases the output per firm and increases the average cost of production.

• When firms sell the same product at different locations, the larger number of firms, the higher the average cost of production.

• The higher production costs are at least partly offset by lower travel costs.

• Product diffraction is what makes the monopolistic competition different from perfect competition.

  • Perfectly competitive firms produce homogeneous products, while monopolistically competitive firms produce differentiated products.

26.4 Advertising for Product Differentiation

• Product differentiation is a key feature of monopolistic competition.

• A firm can use advertising to inform consumers about the features of its product and thus distinguish its product from the products of other firms.

  • Advertisements can inform consumers about prices.

• Some advertisements don’t provide any real information about the product or its price.

  • These sorts of advertisements are designed to promote an image for a product, not to provide information about the product’s features

• An advertisement that doesn’t provide any product information may actually help consumers make decisions.

  • Firms spend millions of dollars to get celebrities to endorse their product.

  • When a celebrity appears in an advertisement for a product, everyone realizes the celebrity is dong the advertisement for money, not to share their enthusiasm for the advertised product.

  • Nonetheless, these advertisements are effective in increasing sales.