Open Economics Question

Jake, this was so interesting I had to refresh my memory on monopolistic competition to provide an answer. It's useful to distinguish between short and long-run equilibriums.

Short answer: yes, monopolistic competition creates a dead-weight loss. This is because firms, even in the long-run equilibrium, are producing at less than their lowest cost levels.

Now, what the diagrams don't capture is that consumers value brand names to some extent. Seeing a McDonald's in an unknown locale gives a sense of security.

But brand names are also damaging somewhat. Companies have incentive to research and exploit consumer psychology. Beers that don't taste very good can capture a market because of brand names.

So it's something of an open question whether the benefits of brand names outweigh the dead-weight loss.

My answer would be that in a context of monopolistic competition there is no "market" as opposed to a firm - just as there isn't in the case of a monopolist. Each firm has their own product, hence their own market. And the deadweight loss is comparing a market with that one firm, to a market with price taking firms competing.

When there's a single price point, monopolies are inefficient at the market level. The cause of this is that there are still transactions that would yield a surplus at a lower price that the monopoly has to forego in order to keep the price up. It is analogous to a tax on the good in the sense that there are transactions that would yield a surplus which don't occur because the tax is larger than the surplus.

Monopolies can become more efficient (in the sense of not passing up transaction with some consumer or producer surplus) by charging different consumers different prices based on how much they'd pay. The extreme case of this, referred to as perfect price discrimination, charges the consumer exactly the maximum amount they'd pay for the good as long as it's above the marginal cost of production for the monopoly. This state actually is efficient in the above sense since the entire potential surplus is realized and it all goes to the monopolist. Price discrimination is difficult to pull off in practice since it requires knowledge of the customer's preferences.

OK, so that makes more sense to me now.

Here is my second question though:

So you know how at long-term equilibrium -- if such a thing exists -- the efficient scale determines the number of firms in a market under perfect competition.

Does the operation of firms under monopolistic competition below the efficient scale suggest that there would be more of them vis-a-vis a market with perfect competition?

Thus, do branding and product differentiation tend to increase the number of firms in a market at the expense of efficiency (sort of what Presh was saying)?

Or am I just trying to stuff them all in a common market again, when no such common market exists (sort of what Maria was saying)?

Thank you for your answers, guys. I really appreciate it.

Ooops - I answered a different question yesterday. My bad for commenting without caffeine.

As for the actual question, there is some deadweight loss at the market level from cases where there are consumers that value the good at above it's marginal cost by an amount that's below it's price - MC but is larger than how much they value the substitute over it's price. Monopolistic competition doesn't have to have a deadweight loss under an optimal pricing strategy - if the difference in marginal cost is equal to the difference in how much consumers value the goods, the firms will price at their marginal cost.

You may get more firms producing substitutes than with undifferentiated goods, but the average cost-based analysis doesn't apply since you now have several different production curves. The average cost-based analysis can be used to determine how many firms will make perfect substitutes of a particular good if it is possible to do so - multiple firms competing in this way can create a pocket of perfect competition for a certain substitute and drive the price of it down accordingly. Often there are barriers to creating perfect substitutes, so each firm is a monopolist in it's little niche. If every firm has perfect substitute competitors, then you're back to the perfect competition model.