Monopolistic Competition Chapter Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives The monopolistic competitor in the short and long runs Product differentiation The characteristics of monopolistic competition Price discrimination 24-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

A monopolistically competitive industry has many firms selling a differentiated product –Differentiated means the buyer, for whatever reason, make a difference between one product and another Identical means the buyer makes no difference between one product and anther product –No one firm has any significant influence on price 24-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Monopolistic Competition Defined

24-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolistic Competitor in the Short Run The monopolistic competitor can make a profit or take a loss As only one firm in a crowded industry it has a very elastic demand curve No one firm can get too far out of line on price because buyers can always purchase a substitute from someone else

24-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolistic Competitor in the Short Run The monopolistic competitor can make a profit or take a loss As only one firm in a crowded industry it has a very elastic demand curve No one firm can get too far out of line on price because buyers can always purchase a substitute from some one else D MR Monopolistic competitor DMR Monopoly

24-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Monopolistic Competitor Making a Profit in the Short Run Output is 60 Price is $15 ATC is $12.10 Total Profit=(Price-ATC) X Output =($15-$12.10) X 60 =($2.90) X 60 = $174

24-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Monopolistic Competitor Taking a Loss in the Short Run Output is 42 Price is $11 ATC is $12.80 Total Profit=(Price-ATC) X Output =($11-$12.80) X 42 =(-$1.80) X 42 = -$75.60

24-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Monopolistic Competitor Breaking Even in the Long Run Output is 40 At the output level associated with MC=MR, the ATC curve is tangent to the demand curve

24-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Monopolistic Competitor Breaking Even in the Long Run Output is 40 Price is $12.10 ATC is $12.10 Total Profit=(Price-ATC) X Output =($12.10-$12.10) X 42 =( 0 ) X 42 = 0

24-10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Monopolistic Competitor Breaking Even in the Long Run Price is $12.10 ATC is $12.10 Total Profit=(Price-ATC) X Output =($12.10-$12.10) X 42 =( 0 ) X 42 = 0 The monopolistic competitor makes zero economic profits in the long run

24-11 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Monopolistic Competitor Breaking Even in the Long Run Price is $12.10 ATC is $12.10 Total Profit=(Price-ATC) X Output =($12.10-$12.10) X 42 =( 0 ) X 42 = 0 Because the monopolistic competitor does not produced at the minimum point of its ATC, the perfect competitor is more efficient than the monopolistic competitor

Product Differentiation Product differentiation is crucial to monopolistic competition –Product differentiation takes place in the buyer’s mind If a buyer sees no difference there is no difference In the real world buyers usually do differentiate –Americans are provided with a wide variety of products and services People in other countries rarely get to make all the consumer choices that Americans do and consequently do not engage in nearly as much product differentiation Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Basis for Product Differentiation Physical differences Convenience Ambience Reputations Appeals to vanity Unconscious fears and desires Snob appeal Customized products Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Typical Monopolistic Competitor The monopolistic competitor tries to set his or her product apart from the competition The main way of doing this is through advertising –When this is done successfully, the demand curve becomes more vertical or inelastic Buyers are willing to pay more for a product or service because they believe it is much better than their other choices Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Why Do People Shop at One Store Rather than Another? Ambience Personal attention Convenience Easy credit Free delivery Good service Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Product Differences Product differentiation does not necessarily mean there are any physical differences among products –They might all be the same, but how they are sold may make all the difference There are, of course, some very real physical product differences. –Buyers often differentiate based on real physical differences, but differentiation is still taking place in the buyers mind, and it may or may not be based on real physical differences Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Price Discrimination Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Price discrimination occurs when a seller charges two or more prices for the same good or service –Sometimes it’s bad and sometimes it’s not bad at all –Price discrimination is often disguised as a subsidy to the poor

Some Examples of Price Discrimination –Doctors often charge rich patients more than poor patients They may have one price for those with insurance and another price for those without insurance –Movies in the evening cost more than those in the early afternoon –Senior citizen, youth, and student discounts –New and used cars –Youth fairs on airlines –Evening meals in restaurants often cost more than the same meal at lunch Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Practicing Price Discrimination The firm that practices price discrimination must be able to distinguish between two or more separate groups of buyers Price discriminators must also be able to prevent buyers from reselling the product or service –For example, if a fifteen-year-old could resell his youth fare seat to an adult who could then use it, the price discrimination effort would fail Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Motives for Price Discrimination In most cases, price discrimination is basically a mechanism for rationing goods and services The main motivation for price discrimination is to raise profits –The greater the price discrimination, the greater the profits because buyers lose some of their “consumer surplus” –If price discrimination were carried to its logical conclusion, we would have perfect price discrimination The buyers would lose all of their “consumer surplus” Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

A&P’s Price Discrimination Scheme in the 1940s Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. PriceQDTRTCTotal Profit $.50100$50$20$ Hypothetical Demand Schedule for Canned Peas A&P had an ATC of $.20 a can If A&P could charge only one price it would be $.50 a can

A&P’s Price Discrimination Scheme in the 1940s Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Demand Schedule for Canned Peas by Grade Grade PriceQDTR TCTotal Profit A $ $50 $20 $30.00 B C Total Profit $ By keeping its markets separate rather than charging a single price, A&P was able to make much larger profits A&P still has an ATC of $.20 a can

24-23 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Is the Monopolistic Competitor Inefficient? From a purely economic standpoint...Yes! –The firms do not produce at the minimum point on the ATC –There may be too many firms in most industries Are there too many beauty parlors? Not if you want to get your hair done on Friday afternoon or Saturday morning Are there too many restaurants? Not on Sunday –There may be overdifferentiation Would Americans want the drab businesses that characterize eastern Europe and the old soviet union? Would Americans want only one brand of toothpaste or one brand and model of a car? –In America, it would be hard to imagine a no-frills world

Closing Thoughts More than 99% of the over 23 million business firms in the United States are monopolistic competitors While monopolistic competitors do compete with respect to price, they compete still more vigorously with respect to ambience, service, and the rest of the intangibles that attract customers Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.