For Review

1. What three conditions characterize a monopolistically competitive industry?

(a) Firms sell differentiated products; (b) the industry has enough firms that when one cuts its prices the other firms lose only a small quantity of sales; and (c) the industry has free entry.

2. How does entry by new firms shift the demand curve for the product sold by a firm already in the industry?

It decreases demand for the products sold by firms already in the industry -- as some customers switch to buying from the new entrants instead of the old firms.

3. (a) Why don't monopolistically competitive firms earn economic profits in long-run equilibrium?

New entry reduces economic profit to zero in the long run.

(b) Why do firms stay in business if they earn only zero economic profit?

For the same reason as with perfect competition -- economic profit equals total revenue minus all costs (including implicit costs). So zero economic profit is enough to keep each business from exiting the industry -- the business owner would not gain by exiting.

4. Consider the beach example in Figure 3a in which each of three sellers earns a profit in the short run. (a) Draw a graph showing the demand for Joanne's ice cream, Joanne's marginal and average costs, the quantity of ice cream that Joanne sells, and the price of ice cream. (b) Draw similar graphs in the long run after two new firms have entered the industry and reduced long-run economic profits to zero.

Figures 2(a) and 2(b) on page 354 answer this question.

5. Draw a graph of short-run equilibrium like Figure 1, but raise the ATC curve so that average total cost exceeds the price, and the firm takes a loss in the short run. (Assume that average variable cost is less than the price, so the firm stays in business in the short run.) What happens as the economy moves too long run? Draw a new graph to show the long-run equilibrium.

In the graph below, the profit-maximizing price P₁ is less than average total cost at the profit-maximizing quantity, ATC₁, so the firm makes a loss (its profit is negative). In the long run, some firms exit, which increases demand for the firms that remain in the industry. (This is the opposite of what happens if firms enter, as in Thinking Exercise 4.) As a result of this increase in demand (and marginal revenue) for firms that remain, the long-run equilibrium looks just like Figure 2b on page 354.

6. What is excess capacity and why does long-run equilibrium with monopolistic competition exhibit excess capacity?

A firm has excess capacity if it could reduce its average cost by raising its output.

In long-run equilibrium, a monopolistically competitive firm produces a quantity at which its average total cost curve is tangent to its demand curve (see page 352) -- as in Figure 2b on page 354. Since demand curves slope downward, the average total cost curve must also slope downward at this quantity (because it is tangent to the demand curve). But if the average total cost curve slopes downward at the equilibrium quantity, then the firm could reduce its average total cost by producing more. In other words, the firm has excess capacity.

7. What is nonprice competition?

Nonprice competition occurs when firms compete by providing better-quality products or product characteristics designed to match the preferences of specific groups of consumers.

8. How does monopolistic competition resemble perfect competition and how does it differ? How does it resemble monopoly and how does it differ?

Monopolistic competition and perfect competition are similar in that:

(i) each firms acts independently, without regard to the responses of its competitors, and

(ii) free entry guarantees that firms earn zero economic profits in long-run equilibrium.

Monopolistic competition and perfect competition differ in that:

(i) each monopolistically-competitive firm faces a downward-sloping demand curve (because each produces a differentiated product), while each perfectly-competitive firm is a price taker (facing a perfectly elastic demand curve), and

(ii) under with monopolistic competition the equilibrium price exceeds marginal cost, but under perfect competition the equilibrium price equals marginal cost, and

(iii) monopolistically-competitive firms, unlike perfectly-competitive firms, have excess capacity in long-run equilibrium.

9. Why do competing firms often locate near each other? Why do they often sell products that differ only slightly from the products of their competitors?

Location is a form of nonprice competition. A business can often attract more customers by locating closer to one of its competitors. That way it can be the closest seller to a certain number of customers. The same logic applies to other characteristics or features of a product. A business can often attract more customers by making its characteristics or features almost the same as the products of its competitors. That way its product can have a color, or flavor, or other characteristic, closer to what most customers want.

10. What issues are involved in evaluating the economic efficiency of a monopolistically competitive industry?

Monopolistic competition tends to be:

• economically inefficient because
• price exceeds marginal cost in long run equilibrium,
• firms have excess capacity (they could reduce average cost erasing output).
• economically efficient because
• it creates product variety, which buyers may like,
• price must equal (at least) average cost in long run equilibrium in to ensure that firms don't lose money; therefore price must exceed marginal cost in the long-run equilibrium of a decreasing-cost industry (see p. 266).

11. (a) Why do monopolistically competitive firms advertise? Why don't perfectly competitive firms advertise? (b) Present a case in favor of advertising. (c) Present a case against advertising.

(a) Price exceeds marginal cost with monopolistic competition. Consequently, each firm can increase its profit by attracting more customers. Therefore each firm under monopolistic competition has an incentive to advertise to try to attract new customers. In contrast, under perfect competition, price equals marginal cost. Consequently, each firm's proper remains unchanged if the number of its customers rises. Therefore a firm under perfect competition has no incentive to spend money on advertising to attract new customers.

(b) Advertising can be good because:

• it provides information about:
• product availability
• features and uses of products
• prices of products
• quarter by various products
• it encourages competition by providing the information listed above (for example, in a famous study of eyeglasses mentioned in the textbook)
• it reminds people that certain products are available
• it provides entertainment
• it creates images -- which people like -- associate with products (for example, some people enjoy wearing are using a product that other people tends to associate with some celebrity)
• it gives producers an incentive to improve service and raise quality

(c) Advertising can be bad because:

• it is socially wasteful --the time and talent that people spend creating advertisements could be spent producing products that people really want
• it leads people to buy things that they don't really want
• it creates wasteful product differentiation -- people do really need so many different varieties of breakfast cereal, toilet tissue, shoes, etc.

12. What arguments can you advance for the economic inefficiency of monopolistic competition? What arguments can you advance for benefits to society for monopolistic competition?

See the answers above to Thinking Exercise 10 and Problem 11.

13. (This is the same question as Thinking Exercise 5. Surprisingly, the answer is also the same!)

14. Over 100,000 fast-food restaurants operate in the United States. Some people say that these restaurants have been overbuilt, that the industry has excess capacity. Can this be a long-run equilibrium? Explain.

Yes, it can be a long-run equilibrium. Monopolistically competitive firms --- such as restaurants --- have excess capacity in long-run equilibrium. They could reduce average cost by raising their output (e.g. by serving more people at times when they are not very busy).

15. Apply the economic analysis and this chapter to explain why politicians often take middle-of-the-road positions on issues in public, even if they privately hold more liberal or conservative views than their public positions indicate.

Just as firms in the monopolistically competitive industry tend to locate close to each other to attract the largest number of customers (and the highest profits), or to make their products similar (for the same reason), politicians tended take similar views on issues in public to attract the largest number of voters.

16. Three hot dog stands planned operate around Circle Lake (which, surprisingly enough, has the shape of a circle). People live in apartments evenly spaced around the lake. Draw picture of Circle Lake and show locations for the three hot dogs stands that are consistent with equilibrium, so that no stand wants to move to a different location.

The first figure below shows one of the possible equilibrium situations -- the hot-dog stands are evenly spaced around the lake.

The second pictures shows a situation that is NOT an equilibrium, because one of the stands has an incentive to move -- in that picture, Stand B gets very few customers because most people are closer to either A or C, which are located near B on each side. So Stand B has an incentive to move far away -- to the ice-cream stand at the South end of the lake.

The third picture shows another equilibrium situation. This time Stand A is at 11:00 (thinking of the circle as a clock), Stand C is at 1:00, and Stand B is at 6:00. Stand B makes a larger profit than the others, but you can convince yourself that no stand gains by moving. (Stand C, for example, loses as many customers to A as it gains from B if it moves southeast along the lake (away from A, toward B); its move would hurt B but help A, without increasing its own profits. (To see a simpler, extreme case of this, suppose that A and C are both at the same place, 12:00, and B is at 6:00. Then A and C split equally the customers who live between 9:00 and 3:00 on the north side, while B gets all the customers who live between 3:00 and 9:00 on the south side. If C moves to, say, 3:00, it will get all (and only) the customers who live between 1:30 and 4:40, which is exactly the same number of customers C got when it was at 12:00 along with A. Therefore B has no incentive to move from 12:00 to 3:00. You can show that the same holds for other locations.)