15 CHAPTER S LIDES BY S OLINA L INDAHL Monopolistic Competition and Product Differentiation

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What you will learn in this chapter  The meaning of monopolistic competition monopolistic competition  Why oligopolists and monopolistically competitive firms differentiate their products differentiate their products  How prices and profits are determined in monopolistic competition in the short run and the long run prices and profits short run long run  Why monopolistic competition poses a trade-off between lower prices and greater product diversity lower prices and greater product diversity  The economic significance of advertising and brand names brand names To Video To Video COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Monopoly Competition Monopolistic competition Oligopoly More competitionLess competition (less price control)(more price control) YOU ARE HERE COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Monopolistic competition is a market structure that’s a little like monopoly and a little like perfect competition. Specifically:  many competitors  products similar but not identical  free entry into and exit from the industry in the long run Restaurants: monopolistic competitors COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Product differentiation plays a crucial role in monopolistic competition. Tacit collusion is almost impossible when there are many producers. Product differentiation is the only way these firms can acquire some market power. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents There are three important forms of product differentiation: Differentiation by style or type sedans vs. SUVs Differentiation by location dry cleaner near home vs. cheaper dry cleaner far away Differentiation by quality ordinary ($) vs. gourmet chocolate ($$$) COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents There are two important features of industries with differentiated products. Competition among sellers : Entry by more producers reduces the quantity each existing producer sells. Value in diversity: Consumers gain from the increased diversity of products. COPYRIGHT 2015 WORTH PUBLISHERS

IN ACTION Back to Table of contents ECONOMICS Any color, so long as it’s black Ford’s strategy was to offer just one style of car, which maximized his economies of scale but made no concessions to differences in taste. Alfred P. Sloan of GM challenged this strategy by offering a range of car types, differentiated by quality and price. By the 1930s the verdict was clear: Customers preferred a range of styles! COPYRIGHT 2015 WORTH PUBLISHERS

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Back to Table of contents Profit MR D MC ATC Z Q P Price, cost, marginal revenue Quantity Same profit maximizing rule as previously used: 1.Produce the Q at which MR = MC. 2.Like monopoly firms, set price according to demand. This profit will attract new entrants. This profit cannot last. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents v To identify the profit-maximizing output for this firm in the short run, this graph needs: a)the market price identified. b)the MR c urve identified. c)the AVC c urve identified. d)All of the answers are true. e)Answers (b) and (c) are true. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents New entrants mean fewer customers for the original firms: Demand and MR shift left. (Economic) profits fall to zero: Firms break even and new entry stops. Profit MR D MC ATC Q P Price, cost, marginal revenue Quantity P = ATC Q COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents New exits mean more customers for the remaining firms: Demand and MR shift right. (Economic) profits fall to zero: Firms break even and exits stop. Loss MR D MC ATC Q Price, cost, marginal revenue Quantity P = ATC Q COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents MR MC D MC MC Z Q MC P MC =ATC MC Point of tangency Price, cost, marginal revenue Quantity ATC COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents If firms are earning economic profits, new firms will want to enter the industry. This will reduce the demand curve facing each individual producer. In the long run, each supplier will earn normal profits, and price will equal ATC. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents MC ATC (b) Long-run equilibrium in monopolistic competition MC ATC P MC =ATC MC MC Q PC Q MC D MC MR MC P PC = MC PC = ATC PC D = MR = P PC (a) Long-run equilibrium in perfect competition Price, cost, marginal revenue Minimum-cost output Quantity COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Firms in a monopolistically competitive industry have excess capacity: They produce less than the output at which average total cost is minimized. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Price > MC, so some mutually beneficial trades are unexploited. COPYRIGHT 2015 WORTH PUBLISHERS

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Back to Table of contents Oligopolies and monopolistically competitive firms advertise. Is advertising good or bad? Yes. (There are different types of advertising.) COPYRIGHT 2015 WORTH PUBLISHERS

IN ACTION Back to Table of contents ECONOMICS THE PERFUME INDUSTRY: LEADING CONSUMERS BY THE NOSE Only 3% of a perfume bottle’s cost is ingredients… the rest is marketing and packaging. Studies show that people identify their favorite scents based on ego and branding… and often dislike the same scents in blind tests. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Advertising as part of the product: Even if NO information is given, does “branding” make the product more enjoyable? Tasters enjoy the cola more if it’s labeled “Coke”… COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents “Informative” advertising: price, quality and availability information COPYRIGHT 2015 WORTH PUBLISHERS

IN ACTIONECONOMICS THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION Real estate agents look a lot like Monopolistic Competitors… except that they collected a high price that never changed (6% commission) Why? They controlled the MLS (Multiple Listing Service) They refused to work with discounters What has changed? Justice department sued the national agents’ group Housing crash forced commissions down COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Advertising as Signaling “If they’re spending so much $$$ on advertising for this product, they must expect it to be profitable and around a long time. Must be good.” COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents In this engaging TED talk, Rory Sutherland makes the daring assertion that a change in perceived value can be just as satisfying as what we consider “real” value—and his conclusion has interesting consequences for how we look at life. (16 minutes)this COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents In your opinion, is advertising “worth it” for society? a)Yes b)No COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents GILETTE VERSUS SCHICK: A CASE OF RAZOR BURN? Competitive razor launches and their huge advertising budgets: are they worth it? Do you pay more for the innovation of the Hydro5, Fusion Pro-Glide with FlexBall TM ? Or are you joining the Dollar Shave Club? COPYRIGHT 2015 WORTH PUBLISHERS