CHAPTER 16 Monopolistic Competition and Product Differentiation

2 Monopolistic Competition = Competitive Competition; Example: Fast Food!  there are many buyers and sellers  each producer sells a differentiated product (products similar, but not identical)  there is free entry and exit in the long run.  few barriers to entry  sellers are price searchers, not price takers

3 Product Differentiation is key! Tacit collusion is virtually impossible when there are many producers. Product differentiation is the only way monopolistically competitive firms can acquire some market power.

4 Three forms of Product Differentiation  Differentiation by style or type – Sedans vs. SUV’s; VW Bugs; Square hamburgers  Differentiation by location – Dry cleaner near home vs. Cheaper dry-cleaner farther away  Differentiation by quality – Ordinary ($) vs. gourmet chocolate ($$$)

5 Product Differentiation causes…  Competition among sellers: Producers compete for the same market, so entry by more producers reduces the quantity each existing producer sells at any given price.  Example – food court in a mall  Value in diversity: In addition, consumers gain from the increased diversity of products.

6 Understanding Monopolistic Competition Some features typical of monopoly + some features typical of perfect competition:  Because each firm is offering a distinct product, it is in a way like a monopolist: it faces a downward-sloping demand curve and has some market power—the ability within limits to determine the price of its product.  However, unlike a monopolist, a monopolistically competitive firm does face competition: the amount of its product it can sell depends on the prices and products offered by other firms in the industry.

7 The Monopolistically Competitive Firm in the Short Run  The firm looks like any monopolist: it faces a downward-sloping demand curve, which implies a downward-sloping marginal revenue curve.

8 The firm in panel (a) can be profitable for some output levels: the levels at which its ATC, lies below its demand curve, D P. The profit-maximizing output level is Q P, the output at which marginal revenue, MR P, is equal to marginal cost. The firm above can never be profitable because the ATC lies above its demand curve, D U. The best that it can do if it produces at all is to produce output Q U and charge P U. Any other output level results in a greater loss.

9 Long Run Monopolistic Competition If the typical firm earns positive profits, new firms will enter the industry in the long run, shifting each existing firm’s demand curve to the left. If the typical firm incurs losses, some existing firms will exit the industry in the long run, shifting the demand curve of each remaining firm to the right. In the long run, (zero-profit-equilibrium) firms just break even. The typical firm’s demand curve is just tangent to its average total cost curve at its profit- maximizing output.

10 The Long-Run Zero-Profit Equilibrium If existing firms are profitable, entry will occur and shift each firm’s demand curve leftward. If existing firms are unprofitable, each firm’s demand curve shifts rightward as some firms exit the industry. In long-run zero profit equilibrium, the demand curve of each firm is tangent to its average total cost curve at its profit-maximizing output level. A monopolistically competitive firm is like a monopolist without monopoly profits.

11 Entry and Exit into the Industry Shift the Demand Curve of Each Firm Think about a food court at the shopping mall. If a new food seller opens, the demand for the existing restaurants drops. (Demand shifts left) Entry and exit will end when the remaining firms make zero profit.

12 Long Run Monopolistic Competition In the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit. Price exceeds marginal cost so some mutually beneficial trades are exploited.

13 Panel (a) shows the situation of the typical firm in long-run equilibrium in a perfectly competitive industry. The firm operates at the minimum-cost output Q C, sells at the competitive market price P C, and makes zero profit. It is indifferent to selling another unit of output because P C is equal to its marginal cost, MC C.

14 Panel (b) shows the situation of the typical firm in long-run equilibrium in a monopolistically competitive industry. At Q MC it makes zero profit because its price, P MC, just equals average total cost. At Q MC the firm would like to sell another unit at price P MC, since P MC exceeds marginal cost, MC MC. But it is unwilling to lower price to make more sales. It therefore operates to the left of the minimum-cost output and has excess capacity.

15 Is Monopolistic Competition Inefficient? Firms in a monopolistically competitive industry have excess capacity: they produce less than the output at which average total cost is minimized. Consumers pay higher prices because of excess capacity, but receive value from greater diversity.

16 Typical methods of Product Differentiation  advertising and  brand names

17 The Role of Advertising Firms advertise in order to increase the demand for their products. Advertising is not a waste of resources when it gives consumers useful information about products. (yellow pages) (signs on interstate highway for food or gas stations)

18 Advertising that simply flaunts a product is harder to explain. Either consumers are irrational, or expensive advertising communicates that the firm's products are of high quality, and they can afford to advertise. (AFLAC goose) (beer ads) (GEICO –Hey you woodchucks, stop chucking my wood! )

19 Brand Names A brand name is a name owned by a particular firm that distinguishes its products from those of other firms. As with advertising, the social value of brand names can be ambiguous. The names convey real information when they assure consumers of the quality of a product.

20 The End of Chapter 16