Chapter 16: Monopolistic Competition

Section 1

Between Monopoly and Perfect Competition

Walk into a bookstore. There are thousands of books to choose from, and anyone can write and publish one. That sounds competitive. But each book is unique — no one else sells exactly this novel — so the publisher has some latitude to set its price. A hardcover sells for around $25 even though the marginal cost of printing one more copy is under $5. That's not how a perfectly competitive market behaves.

The market for books is monopolistically competitive: a little bit monopoly, a little bit competition. Mankiw defines this market structure by three attributes.

Section 2

The Short Run: Acts Like a Mini-Monopoly

In the short run, a monopolistically competitive firm is basically a miniature monopolist. Because its product is differentiated, it faces its own downward-sloping demand curve. That means the exact same math you used for monopoly carries over: MR < P, and the profit-maximizing quantity is where MR = MC.

If the chosen price is above ATC at that quantity, the firm earns a short-run economic profit. If price is below ATC, it takes losses. Either situation is possible in the short run — the diagram looks just like a monopoly's, except the demand curve is the demand for this one firm's version of the product, not the whole market.

Short-run profit: exactly like a monopoly diagram. Q where MR = MC, read P off demand, profit = (P − ATC) × Q. Losses look identical, just with ATC above P.

Section 3

The Long Run: Entry Drives Profit to Zero

Here's where monopolistic competition parts ways with monopoly. A monopoly can keep earning profits forever because barriers to entry keep competitors out. A monopolistically competitive firm has no such protection. If firms are earning profits, new firms will enter — they'll introduce their own slightly different versions of the product.

Every new competitor steals some customers from incumbents. Each firm's demand curve shifts left. Entry continues until the typical firm's profit is driven to zero. Conversely, if firms are taking losses, some exit, demand for each survivor rises, and losses shrink back toward zero.

Long-run equilibrium: the demand curve just touches ATC at the profit-max Q. P = ATC, so profit is zero. MR still crosses MC at the same quantity.

Two things to notice in the long run:

Section 4

Excess Capacity and the Markup

Even though long-run profit is zero in both monopolistic and perfect competition, the two outcomes look very different up close. Two gaps stand out.

1. Excess Capacity

In perfect competition, long-run entry pushes each firm all the way down to the minimum of its ATC curve — the efficient scale. In monopolistic competition, the tangency between D and ATC happens on the downward-sloping part of ATC, to the left of the minimum.

A monopolistically competitive firm is therefore always running with excess capacity: if it produced a bit more, its average cost would fall. But it doesn't, because selling that extra output would require cutting price (demand slopes down) on every unit, which is not profit-maximizing.

2. Markup over Marginal Cost

Perfect competition gives you P = MC. Monopolistic competition gives you P > MC. That gap — the markup — exists because the firm has a tiny bit of market power from its differentiated product.

Mankiw has a nice quip: "monopolistically competitive markets are those in which sellers send Christmas cards to the buyers." A perfectly competitive firm doesn't care whether one more customer walks through the door — each unit just earns zero marginal profit. A monopolistically competitive firm is always happy to sell one more unit at the posted price, because P > MC means that extra sale is a real win.

Monopolistic competition (left) produces below the efficient scale (excess capacity) and charges P > MC (markup). Perfect competition (right) produces at minimum ATC and sets P = MC.

Is This Efficient?

Monopolistically competitive markets don't achieve the efficient outcome of perfect competition. P > MC means some consumers who value the good above its marginal cost still don't buy it — the standard deadweight loss of monopoly pricing. And the number of firms (and therefore the variety of products) could be too large or too small relative to the social optimum.

Section 5

Advertising

Because products are differentiated and prices exceed marginal cost, every monopolistically competitive firm has an incentive to advertise — an extra customer is genuinely profitable. That's why cereal, soda, and clothing brands spend 10–20% of revenue on ads, while wheat farmers and salt miners spend nothing.

Is advertising good or bad for society? Economists have argued both sides for decades.

Advertising as a Signal

What about the ads that don't seem to say anything — George Clooney holding an espresso machine, a celebrity smiling at a watch? Mankiw's signaling story says the expense is the message. A firm that knows its product is good is willing to spend a lot on advertising because it expects repeat business. A firm with a bad product isn't, because the ad spend won't be recouped. So the willingness to waste money on ads is itself a rational signal of product quality — even when the ad contains no literal information.

Brand Names

Brand names run on the same logic. Critics say they're an irrational surcharge for a product that's basically identical to the generic. Defenders say brands give consumers reliable information about quality and give firms a reputation to protect — if a McDonald's in a strange city makes you sick, the reputational damage spreads to every other McDonald's, so the chain has a powerful incentive to keep quality up. Without brands, each local restaurant would have much weaker incentives to police itself.