Page 378 - The Principle of Economics

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PART FIVE
FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
N The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.
N The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.
Thus, in a monopolistically competitive market, there are both positive and nega- tive externalities associated with the entry of new firms. Depending on which ex- ternality is larger, a monopolistically competitive market could have either too few or too many products.
Both of these externalities are closely related to the conditions for monopolis- tic competition. The product-variety externality arises because a new firm would offer a product different from those of the existing firms. The business-stealing ex- ternality arises because firms post a price above marginal cost and, therefore, are always eager to sell additional units. Conversely, because perfectly competitive firms produce identical goods and charge a price equal to marginal cost, neither of these externalities exists under perfect competition.
In the end, we can conclude only that monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. That is, the invisible hand does not ensure that total surplus is maximized under monopolistic competition. Yet because the inefficiencies are subtle, hard to mea- sure, and hard to fix, there is no easy way for public policy to improve the market outcome.
QUICK QUIZ: List the three key attributes of monopolistic competition. N Draw and explain a diagram to show the long-run equilibrium in a monopolistically competitive market. How does this equilibrium differ from that in a perfectly competitive market?
FYI
Is Excess Capacity a Social Problem?
As we have seen, monopolisti- cally competitive firms produce a quantity of output below the level that minimizes average to- tal cost. By contrast, firms in per fectly competitive markets are driven to produce at the quantity that minimizes average total cost. This comparison be- tween per fect and monopolistic competition has led some economists in the past to ar- gue that the excess capacity of
evaluating economic welfare. There is no reason that soci- ety should want all firms to produce at the minimum of average total cost. For example, consider a publishing firm. Producing a novel might take a fixed cost of $50,000 (the author’s time) and variable costs of $5 per book (the cost of printing). In this case, the average total cost of a book de- clines as the number of books increases because the fixed cost gets spread over more and more units. The average to- tal cost is minimized by printing an infinite number of books. But in no sense is infinity the right number of books for so- ciety to produce.
In short, monopolistic competitors do have excess ca- pacity, but this fact tells us little about the desirability of the market outcome.
monopolistic competitors was a source of inefficiency. Today economists understand that the excess capac- ity of monopolistic competitors is not directly relevant for