Unit 5: Monopoly, Monopolistic Competition, and Oligopoly Lecture #2, Monopolistic Competition Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Think and Compare Before moving forward… Think about the characteristics of the market structures we have studied Think about how monopolistically competitive firms are similar/dissimilar to those that are perfectly competitive or monopolists In monopolistic competition, firms can differentiate their products by the product attributes, by service, with location, or with brand names and packaging. There is relatively easy entry and exit, just not as easy as with perfect competition. That is why the number of sellers is not as large as in perfect competition, but it is relatively large. This type of market experiences some pricing power due to the differentiated product. If a firm goes to the trouble and expense of differentiating their product they should let people know about it. They can do this through advertising. 11-2 LO1

Monopolistic Competition Relatively large number of sellers Differentiated products Easy entry and exit Need to advertise In monopolistic competition, firms can differentiate their products by the product attributes, by service, with location, or with brand names and packaging. There is relatively easy entry and exit, just not as easy as with perfect competition. That is why the number of sellers is not as large as in perfect competition, but it is relatively large. This type of market experiences some pricing power due to the differentiated product. If a firm goes to the trouble and expense of differentiating their product they should let people know about it. They can do this through advertising. 11-3 LO1

Monopolistically Competitive Based on # of firms in an industry and percent of market share Measured by two methods: Four-firm Concentration Ratios Percentage of market held by 4 largest firms Herfindahl Index Measured by summing squared % of market shares held by firms in an industry 10,000 is the highest (1 firm with 100% of the market = 1002 Four-firm concentration ratios are a measure of industry concentration. Four-firm concentration ratios are low in monopolistically competitive firms as in the table on the next slide. One of the cautions of using these is that they reflect national output (sales numbers) and would not be reflective of a localized monopoly. Herfindahl index – the lower the HI, the more competitive the industry. The Herfindahl Index is another measure of industry concentration and it is the sum of the squared percentage of market shares of all firms in the industry. Generally speaking, the lower the Herfindahl, the lower the industry concentration. 11-4 LO1

Low Concentration Industries (1) Industry (2) 4-Firm Concentration Ratio (3) Herfindahl Index Asphalt paving 25 207 Metal windows and doors 14 114 Plastic pipe 24 262 Women’s dresses 13 84 Textile bags 263 Ready mix concrete 11 63 Bolts, nuts, and rivets 205 Wood trusses 10 50 Plastic bags 23 240 Stone products 59 Quick printing 22 319 Metal stamping 8 31 Textile machinery 20 206 Wood pallets 7 Sawmills 18 117 Sheet metal work 6 Jewelry 16 Signs 5 19 Curtains and draperies 111 Retail bakeries 4 This table shows some examples of U.S. manufacturing industries that are considered monopolistically competitive. The lower the 4-firm concentration ratio, the less concentration and subsequently, the more competitive the industry. Generally speaking, the lower the Herfindahl index, the lower the industry concentration. Source: Bureau of Census, Census of Manufacturers, 2002 11-5 LO1

Price and Output in Monopolistic Comp Demand is highly elastic Short-run profit or loss occur Produce where MR=MC Only long-run normal profit Firms enter and exit based on profit opportunity Inefficient Product variety The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price. In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that. Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient. 11-6 LO2

Price and Output in Monopolistic Comp Produce where P > MC Not socially optimal output Deadweight Loss results Not possible to regulate Too many firms Too many differentiated products The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price. In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that. Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient. 11-7 LO2

The Short Run: Profit Price and Costs Quantity ATC MC P1 A1 Economic MR = MC Firms produce the quantity where MR = MC just like in other industries. It is possible to make a profit in the short run. (Price – ATC) * Q = Economic profit. At the profit maximizing output, price is higher than ATC and the firms enjoy an economic profit in the short run. MR Q1 Quantity 11-8 LO2

The Short Run: Profit Short-run economic profits encourage new firms to enter the market. This: Increases the number of products. Reduces demand of current firms. Current firms profits fall. The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price. In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that. Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient. 11-9 LO2

The Short Run: Loss Price and Costs Loss Quantity ATC MC A2 P2 D2 MR = MC Firms will produce the quantity where MR = MC to maximize profits. It is possible to make a loss in the short run. (Price – ATC) * Q = Economic profit or loss. At the profit maximizing output, price is below ATC and therefore a loss is incurred. MR Q2 Quantity 11-10 LO2

The Short Run: Loss Short-run economic losses encourage firms to exit the market. This: Decreases the number of products. Increases demand of remaining firms. Increases the remaining firms’ profits. The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price. In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that. Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient. 11-11 LO2

The Long Run: Only a Normal Profit MC ATC P3= A3 Price and Costs D3 MR = MC In the long run firms still produce the quantity where MR = MC. In the long run firms will enter the industry if economic profits were enjoyed, shifting demand left and profits fall. In the long run firms will exit the industry if there are economic losses, shifting demand to the right and losses shrink. This will continue until the price settles where it just equals ATC at the MR=MC output. At this price, the monopolistically competitive firm earns a normal profit. MR Q3 Quantity 11-12 LO2

Long-Run Normal Profits Why do monopolistically competitive firms only earn normal profits in the long-run? The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so the firm has some control over price. In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that. Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry. As we examine the industry, we will find that it is inefficient. 11-13 LO2

Monopolistic Competition: Efficiency Inefficient use of resources Excess capacity (not found in Perfect Comp) Productive inefficiency P > ATC Additional capacity possible if production occurred at ATC Allocative inefficiency P > MC Resources could be better-used with a different product Productive Efficiency means that the firm is producing in the least costly way and is evidenced when P = min ATC. Allocative Efficiency means that the firm is producing the right amount of output and is evidenced when P = MC. 11-14 LO2

Monopolistic Competition: Not Efficient P=MC=Min ATC for pure competition (recall) Quantity Price and Costs MR = MC MC MR D3 ATC Q3 P3= A3 P4 Price is Lower We can see the inefficiency of monopolistic competition. In long-run equilibrium a monopolistic competitor achieves neither productive nor allocative efficiency. Productive efficiency is not realized because production occurs where the average total cost A3 exceeds the minimum average total cost A4. Allocative efficiency is not achieved because the product price P3 exceeds the marginal cost. The results are an underallocation of resources as well as an efficiency loss and excess production capacity for every firm in the industry. This firm’s excess production capacity is Q4 - Q3. Excess Capacity at Minimum ATC Q4 Monopolistic competition is not efficient 11-15 LO2

Product Variety The firm constantly manages price, product, and advertising. Better product differentiation Better advertising The consumer benefits by greater array of choices and better products. Types and Styles Brands and Quality Monopolistically competitive producers may be able to postpone the long-run outcome of just normal profits through product development, improvement, and advertising. Compared with pure competition, this suggests possible advantages for the consumer. Development, or improved products, can provide the consumer with a diversity of choices. Product differentiation is at the heart of the trade-off between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem. 11-16 LO2

Advertising and Branding Does advertising increase competition and provide useful information to consumers or is it used to simply manipulate our tastes and preferences? Are brand names an indicator of quality or do they cause consumers to perceive differences that do not really exist? Monopolistically competitive producers may be able to postpone the long-run outcome of just normal profits through product development, improvement, and advertising. Compared with pure competition, this suggests possible advantages for the consumer. Development, or improved products, can provide the consumer with a diversity of choices. Product differentiation is at the heart of the trade-off between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem. 11-17 LO2