Chapter 26 - Market Entry and Monopolistic Competition

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.

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.

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.

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.

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