Mostly summarized from Gregory Mankiw’s Principles of Economics, 5^th Ed.

PART 5 Firm Behavior and the Organization of Industry

Chapter 16 of 36 Monopolistic Competition   

Section 10 of 16

…

Figure 3a here

…

We have evaluated markets from the view of efficiency, whether society is getting the most from scarce resources.

We noted in the two extreme cases

· perfectly competitive markets lead to efficient outcomes, unless there are externalities such as pollution

· monopoly markets create deadweight losses, due to pricing above marginal cost

Monopolistically competitive markets are more complex, so evaluation of welfare in these markets is subtler.

…

Per Figure 3a one source of deadweight loss inefficiency is the markup of price above marginal cost.

Some potential consumers value the good at more than the marginal cost of production but less than the price.

Because of the higher price these are deterred from buying the good.

Thus, a monopolistically competitive market has the deadweight loss of monopoly pricing.

…

This deadweight loss outcome is undesirable but there is no easy way for policymakers to fix the problem.

To enforce marginal cost pricing policymakers would have to regulate all firms that produce differentiated products.

But because such products are so common in the economy the administrative burden of such regulation would be immense.

Regulation of monopolistic competitors would entail many more problems than with regulating monopolies.

…

Requiring monopolistic competitors to lower their prices to equal marginal cost would cause them to incur losses.

To keep these firms in business the government would have to help them cover these losses.

Rather than raise general taxes to pay the firms subsidies policymakers decide it is better to live with the inefficiency of monopolistic pricing.

…

Another way where monopolistic competition may be socially inefficient is the number of firms in the market may not be ideal.

There may be too much or too little entry of new firms into the market.

When a new firm plans to enter a market with a new product, it considers only the profit it would make.

Yet, its entry would also have two effects external to the firm

·1· positive externality, the product-variety externality

Because consumers get some consumer surplus (willingness to pay more than the product price they pay) from the introduction of a new product entry of a new firm creates a positive externality for consumers.

·2· negative externality,  the business-stealing externality

Because other firms already in the market lose sales and profits from the entry of a new competitor entry of a new firm creates a negative externality for existing firms, their sales volume and price are driven down.

Depending on which of these two externalities is larger a monopolistically competitive market can have either too few or too many firms and products.

In the case of perfectly competitive firms they produce identical products and charge a price equal to marginal cost, so neither of these two externalities exist.

…

We can conclude, with monopolistically competitive markets

· there are not all the desirable economically efficiency properties of perfectly competitive markets

· the invisible hand of the free market does not ensure total (consumer + supplier) surplus is maximized

The inefficiencies of monopolistically competitive markets are subtle, difficult to measure, and hard to fix.

So, there is no practical way for public policy to eliminate the deadweight loss to improve the market outcome.

Price regulation can work in monopoly markets but not in monopolistically competitive ones.