Notes appear on slides 4, 6, 14, and 20.

15 CHAPTER Monopolistic Competition

C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to Describe and identify monopolistic competition. 1 Explain how a firm in monopolistic competition determines its output and price in the short run and the long run. 2 Explain why advertising costs are high and why firms use brand names in monopolistic competition. 3

15.1 WHAT IS MONOPOLISTIC COMPETITION? Monopolistic competition is a market structure in which A large number of firms compete. Each firm produces a differentiated product. Firms compete on price, product quality, and marketing. Firms are free to enter and exit. Students have no difficulty seeing monopolistic competition in the world all around them. Emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of monopolistic competition, as its name implies, is a mixture of both extremes. Some of what they learned in each of the two previous chapters survives and operates in the middle ground of monopolistic competition.

15.1 WHAT IS MONOPOLISTIC COMPETITION? Large Number of Firms Like perfect competition, the market has a large number of firms. Three implications are Small market share No market dominance Collusion impossible

15.1 WHAT IS MONOPOLISTIC COMPETITION? Product Differentation Product differentiation is making a product that is slightly different from the products of competing firms. A differentiated product has close substitutes but it does not have perfect substitutes. When the price of one firm’s product rises, the quantity demanded of that firm’s product decreases. Product differentiation is the heart of the space between monopoly and competition. An old ice-cream on the beach analogy really nails down the idea of product differentiation and explains how monopolistic competition fills the space between monopoly and perfect competition. Draw a line on the blackboard and label the two ends A and B. Tell the students that the line represents a long beach along which beachgoers are uniformly spaced. An ice-cream vendor decides to set up shop on the beach—the only one. Where will she locate? The students will quickly see that the center—midway between A and B is the spot that will get most customers because the cost of an ice-cream is the market price plus the walking time to get it (remind them that the beach is very long!) Now a second ice-cream vendor opens up. Where does he locate? With a bit of help, the students will see that the best spot is right next to the first one. With one producer, there is monopoly and no variety—no product differentiation. With two producers, there is still no differentiation— technically, there is minimum differentiation. Now suppose a third and fourth ice-cream vendor come along. Where do they locate? At the ends of the beach at A and B. They differentiate as much as possible from each other and from the first two. Further entry has new ice-cream vendors locating in the middle of the gaps between the existing ones, always going into the widest gap. If the market could stand the competition, eventually, there would be ice-cream vendors so close to each other all along the beach that the members of any adjacent group were indistinguishable to a customer. Product differentiation would have been pushed to the point that there is no “space” for additional variety and the market would look like perfect competition. Real products are like the beach example. Talk about sports shoes, breakfast cereals, and any other goods that interest you and for which there are good locally observable examples and encourage the students to see that they are like the beach example. The variety of products fill the available variety “space.”

15.1 WHAT IS MONOPOLISTIC COMPETITION? Competing on Quality, Price, and Marketing Quality Design, reliability, after-sales service, and buyer’s ease of access to the product. Price Because of product differentiation, the demand curve for the firms’ product is downward sloping. Marketing Advertising and packaging

15.1 WHAT IS MONOPOLISTIC COMPETITION? Entry and Exit No barriers to entry. So the firm cannot make economic profit in the long run.

15.1 WHAT IS MONOPOLISTIC COMPETITION? Identifying Monopolistic Competition Two indexes: The four-firm concentration ratio The Herfindahl-Hirschman Index

15.1 WHAT IS MONOPOLISTIC COMPETITION? The Four-Firm Concentration Ratio The four-firm concentration ratio is the percentage of the value of sales accounted for by the four largest firms in the industry. The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly. A ratio that exceeds 60 percent is an indication of oligopoly. A ratio of less than 40 percent is an indication of a competitive market—monopolistic competition.

15.1 WHAT IS MONOPOLISTIC COMPETITION? The Herfindahl-Hirschman Index The Herfindahl-Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms in a market. Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent. HHI = 502 + 252 + 152 + 102 = 3,450 A market with an HHI less than 1,000 is regarded as competitive and between 1,000 and 1,800 is moderately competitive.

15.1 WHAT IS MONOPOLISTIC COMPETITION? Limitations of Concentration Measures The two main limitations of concentration measures alone as determinants of market structure are their failure to take proper account of The geographical scope of a market Barriers to entry and firm turnover

15.2 OUTPUT AND PRICE DECISIONS How, given its costs and the demand for its jeans, does Tommy Hilfiger decide the quantity of jeans to produce and the price at which to sell them? The Firm’s Profit-Maximizing Decision The firm in monopolistic competition makes its output and price decision just like a monopoly firm does. Figure 15.1 on the next slide illustrates this decision.

15.2 OUTPUT AND PRICE DECISIONS 1. Profit is maximized when MR = MC. 2. The profit-maximizing output is 125 pairs of Tommy jeans per day. 3. The profit-maximizing price is $75 per pair. While students have gotten familiar with the demand, marginal revenue, and marginal cost curves over the past two chapters, still take the time to point out the curves as you draw them. Use actual numbers for quantity and price Unlike the case of perfect competition, the demand curve for a firm’s differentiated product in monopolistic competition is downward sloping. Remind the students about the ceteris paribus condition that defines a demand curve. Along the demand curve for Nike tennis shoes, the prices of Adidas, Fila, Head, K Swiss, Prince, Reebok, and Wilson tennis shoes are constant. Some people prefer Nike to the other brands and will pay a bit more for Nike. Other people prefer some other brand and will buy Nike only if its price is low enough. Buyers have brand preferences, but they will switch brands if price differences are large enough. So the higher the price of a Nike shoe, the prices of the other brands remaining the same, the smaller is the quantity of Nike shoes demanded. ATC is $25 per pair, so 4. The firm makes an economic profit of $6,250 a day.

15.2 OUTPUT AND PRICE DECISIONS Profit Maximizing Might Be Loss Minimizing Some firms in monopolistic competition have a tough time making a profit. A burst of entry into an industry can limit the demand for each firm’s own product. Figure 15.2 on the next slide illustrates a firm incurring a loss in the short run.

15.2 OUTPUT AND PRICE DECISIONS 1. Loss minimized when MC = MR. 2. The loss-minimizing output is 40,000 customers and 3. The price is $40 per month, which is less than ATC. 4. The firm incurs an economic loss.

15.2 OUTPUT AND PRICE DECISIONS Long Run: Zero Economic Profit Economic profit induces entry and economic loss induces exit, as in perfect competition. Entry decreases the demand for the product of each firm. Exit increases the demand for the product of each firm. In the long run, economic profit is competed away and firms earn normal profit. Figure 15.3 on the next slide illustrates long-run equilibrium.

15.2 OUTPUT AND PRICE DECISIONS 1. The output that maximizes profit is 75 pairs of Tommy jeans a day. 2. The price is $50 per pair. Average total cost is also $50 per pair. Students seem to have a bit of trouble appreciating that entry and exit change the demand for a firm’s product. Explain this effect by sticking with the tennis shoes example. Explain that the demand for Nike tennis shoes changes and the demand curve for Nike tennis shoes shifts if other firms enter or exit. If Tommy Hilfiger and the Gap started to make tennis shoes, some of Nike’s former customers would switch to these two new brands, and the demand for Nike shoes would decrease. The demand curve for Nike shoes would shift leftward. If Adidas, Fila, and Reebok stopped making tennis shoes, some of their former customers would switch to like, and the demand for Nike shoes would increase. The demand curve for Nike shoes would shift rightward. 3. Economic profit is zero.

15.2 OUTPUT AND PRICE DECISIONS Monopolistic Competition and Perfect Competition The two key differences between monopolistic competition and perfect competition are that in monopolistic competition, there is Excess capacity A markup of price over marginal cost

15.2 OUTPUT AND PRICE DECISIONS Excess Capacity A firm has excess capacity if the quantity it produces is less that the quantity at which average total cost is a minimum. A firm’s efficient scale is the quantity of production at which average total cost is a minimum. Markup A firm’s markup is the amount by which price exceeds marginal cost.

15.2 OUTPUT AND PRICE DECISIONS 1. The efficient scale is 100 pairs of jeans a day. 2. The firm produces less than the efficient scale and has excess capacity. 3. Price exceeds 4. marginal cost by the amount of 5. the markup. 6. Deadweight loss arise.

15.2 OUTPUT AND PRICE DECISIONS In perfect competition, 1. The efficient quantity is produced and 2. Price equals marginal cost.

15.2 OUTPUT AND PRICE DECISIONS Is Monopolistic Competition Efficient Deadweight Loss Because price exceeds marginal cost, monopolistic competition creates deadweight loss—an indicator of inefficiency. Making the Relevant Comparison Price exceeds marginal cost because of product differentiation. But product variety is valued. The Bottom Line The bottom line is ambiguous. But compared to the alternative, monopolistic competition looks efficient.

15.3 DEVELOPMENT AND MARKETING Innovation and Product Development Wherever economic profits are earned, imitators emerge. To maintain economic profit, a firm must seek out new products. Cost Versus Benefit of Product Innovation The firm must balance the cost and benefit at the margin.

15.3 DEVELOPMENT AND MARKETING Efficiency and Product Innovation Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which equals the amount the consumer is willing to pay. The marginal benefit to the producer is the marginal revenue, which in equilibrium equals marginal cost. Because price exceeds marginal cost, product improvement is not pushed to its efficient level.

15.3 DEVELOPMENT AND MARKETING Advertising Firms in monopolistic competition spend a large amount on advertising and packaging their products. Advertising Expenditures A large proportion of the prices that we pay cover the cost of selling a good. Figure 15.5 on the next slide shows some estimates of marketing expenditures for some familiar markets.

15.3 DEVELOPMENT AND MARKETING

15.3 DEVELOPMENT AND MARKETING Selling Costs and Total Costs Advertising expenditures increase the costs of a monopolistically competitive firm above those of a perfectly competitive firm or a monopoly. Advertising costs are fixed costs. Advertising costs per unit decrease as production increases. Figure 15.6 on the next slide illustrates the effects of selling costs on total cost.

15.3 DEVELOPMENT AND MARKETING 1. When advertising costs are added to 2. The average total cost of production, 3. Average total cost increases by a greater amount at small outputs than at large outputs.

15.3 DEVELOPMENT AND MARKETING 4. If advertising enables sales to increase from 25 pairs of jeans a day to 100 pairs a day, it lowers the average total cost from $60 a pair to $40 a pair.

15.3 DEVELOPMENT AND MARKETING Selling Costs and Demand Advertising and other selling efforts change the demand for a firm’s product. The effects are complex: A firm’s own advertising increases the demand for its product. Advertising by all firms might decrease the demand for any one firm’s product and make demand more elastic. The price and markup might fall.

15.3 DEVELOPMENT AND MARKETING Figure 15.7 shows the possible effect of advertising. With no advertising, demand is low but the markup is large.

15.3 DEVELOPMENT AND MARKETING With advertising, average total cost increases and the ATC curve becomes ATC1. Demand decreases and becomes more elastic. Profit-maximizing output increases, the price falls, and the markup shrinks.

15.3 DEVELOPMENT AND MARKETING Using Advertising to Signal Quality Some advertising is very costly and has almost no information content about the item being advertised. Such advertising is used to signal high quality. A signal is an action taken by an informed person or firm to send a message to uninformed people. Signaling works because it is profitable to signal high quality and deliver it but unprofitable to signal a high quality product and not deliver it.

15.3 DEVELOPMENT AND MARKETING Brand Names Brand names are also used to provide information about the quality of a product. It is costly to establish a widely recognized brand name. Like costly advertising, a brand name signals high quality. Brand names work because it is unprofitable to incur the cost of creating a brand name and then deliver a low quality product.

15.3 DEVELOPMENT AND MARKETING Efficiency of Advertising and Brand Names Advertising and brand names that provide information about the quality of products enable buyers to make better choices. Advertising and brand name can be efficient if the marginal cost of the information equals its marginal benefit. The final verdict on the efficiency of monopolistic competition is ambiguous.

Selling Costs in YOUR Life When you buy a new pair of running shoes, you’re buying Materials that cost $9 Production costs of $8 U.S. import duty of $3 Selling costs of $50

Selling Costs in YOUR Life Running shoes are not unusual. Almost everything you buy includes a selling cost component that exceeds one half of the total cost. The table provides a detailed breakdown of the cost of a pair of running shoes.