13 Monopolistic Competition: CHAPTER The Competitive Model in a More Realistic Setting Chapter Outline and Learning Objectives 13.1 Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market 13.2 How a Monopolistically Competitive Firm Maximizes Profit in the Short Run 13.3 What Happens to Profits in the Long Run? 13.4 Comparing Monopolistic Competition and Perfect Competition 13.5 How Marketing Differentiates Products 13.6 What Makes a Firm Successful?

Starbucks: The Limits to Growth through Product Differentiation Starbucks coffeehouses provide a unique experience, but that experience is not difficult to copy. The company faces a constant challenge to stay ahead of its competitors and satisfy its customers. Competitive markets share three characteristics: 1) There are many firms; 2) All firms sell identical products; and, 3) There are no barriers to entry. The products that Starbucks and its competitors sell are differentiated, so the market is monopolistically competitive. In these markets, firms are unable to earn economic profit in the long run. AN INSIDE LOOK on page 506 describes how Starbucks acquired a juice maker to expand into areas outside of the coffee business.

Economics in Your Life Opening Your Own Restaurant After you graduate, you plan to realize your dream of opening your own Italian restaurant. You are confident that many people will enjoy the pasta prepared with your grandmother’s secret sauce. Although your hometown already has three Italian restaurants, you are convinced that you can enter this market and make a profit. You have many choices to make in operating your restaurant. Will it be “family style,” with sturdy but inexpensive furniture, where families with small—and noisy!—children will feel welcome, or will it be more elegant, with nice furniture, tablecloths, and candles? Will you offer a full menu or concentrate on pasta dishes that use your grandmother’s secret sauce? These and other choices you make will distinguish your restaurant from competitors. What’s likely to happen in the restaurant market in your hometown after you open? How successful are you likely to be?

Monopolistic competition A market structure in which barriers to entry are low and many firms compete by selling similar, but not identical, products.

Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market 13.1 LEARNING OBJECTIVE Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves.

The Demand Curve for a Monopolistically Competitive Firm Figure 13.1 The Downward-Sloping Demand for Caffè Lattes at a Starbucks If a Starbucks increases the price of caffè lattes, it will lose some, but not all, of its customers. In this case, raising the price from $3.00 to $3.25 reduces the quantity of caffè lattes sold from 3,000 to 2,400. Therefore, unlike a perfect competitor, a Starbucks store faces a downward-sloping demand curve.

CAFFÈ LATTES SOLD PER WEEK (Q) Marginal Revenue for a Firm with a Downward-Sloping Demand Curve Table 13.1 Demand and Marginal Revenue at a Starbucks CAFFÈ LATTES SOLD PER WEEK (Q) PRICE (P) 1 2 3 4 5 6 7 8 9 10 $6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 $0.00 10.00 13.50 16.00 17.50 18.00 ― $5.50 0.50 –0.50 –1.50 –2.50 –3.50 The fourth column shows the firm’s revenue per unit, or its average revenue. Average revenue is equal to total revenue divided by quantity. Because total revenue equals price multiplied by quantity, dividing by quantity leaves just price. Therefore, average revenue is always equal to price.

When the firm cuts the price by $0 When the firm cuts the price by $0.50, one good thing and one bad thing happen: • The good thing. It sells 1 more caffè latte; we can call this the output effect. • The bad thing. It receives $0.50 less for each caffè latte that it could have sold at the higher price; we can call this the price effect. Figure 13.2 How a Price Cut Affects a Firm’s Revenue If the local Starbucks reduces the price of a caffè latte from $3.50 to $3.00, the number of caffè lattes it sells per week will increase from 5 to 6. Its marginal revenue from selling the sixth caffè latte will be $0.50, which is equal to the $3.00 additional revenue from selling 1 more caffè latte (the area of the green box) minus the $2.50 loss in revenue from selling the first 5 caffè lattes for $0.50 less each (the area of the red box).

There is an important general point: Every firm that has the ability to affect the price of the good or service it sells will have a marginal revenue curve that is below its demand curve. Only firms in perfectly competitive markets, which can sell as many units as they want at the market price, have marginal revenue curves that are the same as their demand curves.

Figure 13.3 The Demand and Marginal Revenue Curves for a Monopolistically Competitive Firm Any firm that has the ability to affect the price of the product it sells will have a marginal revenue curve that is below its demand curve. We plot the data from Table 13.1 to create the demand and marginal revenue curves. After the sixth caffè latte, marginal revenue becomes negative because the additional revenue received from selling 1 more caffè latte is smaller than the revenue lost from receiving a lower price on the caffè lattes that could have been sold at the original price.

How a Monopolistically Competitive Firm Maximizes Profit in the Short Run 13.2 LEARNING OBJECTIVE Explain how a monopolistically competitive firm maximizes profit in the short run.

Figure 13.4 Maximizing Profit in a Monopolistically Competitive Market   To maximize profit, a Starbucks coffeehouse wants to sell caffè lattes up to the point where the marginal revenue from selling the last caffè latte is just equal to the marginal cost. As the table shows, this happens with the fifth caffè latte—point A in panel (a)—which adds $1.50 to the firm’s costs and $1.50 to its revenues. The firm then uses the demand curve to find the price that will lead consumers to buy this quantity of caffè lattes (point B). In panel (b), the green box represents the firm’s profits. The box has a height equal to $1.00, which is the $3.50 price minus the average total cost of $2.50, and it has a base equal to the quantity of 5 caffè lattes. So, this Starbucks’s profit equals $1 × 5 = $5.00.

Solved Problem 13.2 Does Minimizing cost Maximize Profits? Suppose Apple finds that the relationship between the average total cost of producing iPhones and the quantity of iPhones produced is as shown in the following graph. Will Apple maximize profits if it produces 800,000 iPhones per month? Briefly explain. Solving the Problem Step 1: Review the chapter material. Step 2: Discuss the relationship between minimizing costs and maximizing profits. The figure shows that by producing 800,000 iPhones per month, Apple will minimize its average cost of production. But remember that the firm’s goal is to maximize profit, not minimize cost. Depending on demand, a firm may maximize profits by producing a quantity that is either larger or smaller than the quantity that would minimize average total cost.

Solved Problem 13.2 Does Minimizing cost Maximize Profits? Step 3: Draw a graph that shows Apple maximizing profit at a quantity where average cost is not minimized. Note that in the graph, average cost reaches a minimum at a quantity of 800,000, but profits are maximized at a quantity of 600,000. Your Turn: Test your understanding by doing related problem 2.6 at the end of this chapter. MyEconLab

What Happens to Profits in the Long Run? 13.3 LEARNING OBJECTIVE Analyze the situation of a monopolistically competitive firm in the long run.

How Does the Entry of New Firms Affect the Profits of Existing Firms? Figure 13.5 How Entry of New Firms Eliminates Profits Panel (a) shows that in the short run, the local Starbucks faces the demand and marginal revenue curves labeled “Short run.” With this demand curve, Starbucks can charge a price above average total cost (point A) and make a profit, shown by the green rectangle. But this profit attracts new firms to enter the market, which shifts the demand and marginal revenue curves to the curves labeled “Long run” in panel (b). Because price is now equal to average total cost (point B), Starbucks breaks even and no longer earns an economic profit.

Is Zero Economic Profit Inevitable in the Long Run? If a firm introduces new technology that allows it to sell a good or service at a lower cost, competing firms will eventually be able to duplicate that technology and eliminate the firm’s profits. But this result holds only if the firm stands still and fails to find new ways of differentiating its product or fails to find new ways of lowering the cost of producing its product. To stay one step ahead of its competitors, a firm has to offer consumers goods or services that they perceive to have greater value than those competing firms offer. Value can take the form of product differentiation, or it can take the form of a lower price. Don’t Let This Happen to You Don’t Confuse Zero Economic Profit with Zero Accounting Profit Remember that economists count the opportunity cost of the owner’s investment in a firm as a cost. Original investment = $200,000 Return on similar investment = 10 percent. Annual opportunity cost of investing the funds = $200,000 x 10% = $20,000. In an economic sense, the $20,000 is a cost. In long-run equilibrium, we would expect that entry of new firms would keep you from earning more than 10 percent on your investment. So, you would end up breaking even and earning zero economic profit, even though you were earning an accounting profit of $20,000. Your Turn: Test your understanding by doing related problem 3.6 at the end of this chapter. MyEconLab

The Short Run and the Long Run for a Monopolistically Competitive Firm Table 13.2 The Short Run and the Long Run for a Monopolistically Competitive Firm Relationship between Price and Marginal Cost Relationship between Price and Average Total Cost Profit and Loss Elasticity of Demand Curve Short Run P > MC Short Run P > MC Short Run Economic profit Short Run Less elastic demand curve or P < ATC or Economic loss Long Run P > MC Long Run P = MC Long Run Zero economic profit Long Run More elastic demand curve

Making the Connection The Rise and Decline and Rise of Starbucks From the mid-1990s through the mid-2000s, Starbucks strategy worked very well, and Starbucks’s opened nearly 17,000 stores worldwide. But Starbucks profitability attracted competitors. In 2009, Starbucks was struggling nationwide as it faced slowing sales and increased competition. By 2011, Starbucks had managed a remarkable turnaround, with its sales and profits increasing. Some of the success came from an expansion in overseas markets, but there were other factors. By 2011, sales and profits at Starbucks were increasing due in part to expansion in overseas markets, such as China, where competition was not as strong as in the United States. The firm gave customers more freedom to customize drinks, started a loyalty program and a mobile payment system, and provided stores with better machines. In a monopolistically competitive industry, maintaining profits in the long run is very difficult. Only by constantly innovating has Starbucks been able to return to profitability after several years of struggling with intense competition from other firms. Your Turn: Test your understanding by doing related problem 3.8 at the end of this chapter. MyEconLab

Solved Problem 13.3 Can It Be Profitable to Be the High-Price Seller? During the year ending in March 2011, hhgregg, an appliance and electronics retailer with stores in the Eastern states, reported that its profits had risen 23 percent. During the same period, Best Buy’s profits declined by 3 percent. Best Buy is much larger than hhgregg, so it is able to buy its appliances, televisions, and other goods from manufacturers at a low price. Because hhgregg must pay higher prices to manufacturers, it must charge higher prices to consumers. How is hhgregg able to succeed in competition with Best Buy, Wal-Mart, Amazon, and other big retailers, despite charging high prices? According to an article in the Wall Street Journal: “hhgregg’s commissioned sales staff is an advantage over national chains with young, lower-paid hourly workers that tend to stay for shorter periods.” hhgregg’s CEO was quoted as saying: “We have sales people that have been with us 10 to 20 years, and customers who come in and ask for them by name.” Use this information to explain how an hhgregg store might be more profitable than a similar Best Buy store, despite the fact that the hhgregg store charges higher prices. Use a graph for hhgregg and a graph for Best Buy to illustrate your answer. Solving the Problem Step 1: Review the chapter material.

Solved Problem 13.3 Can It Be Profitable to Be the High-Price Seller? Step 2: Explain how hhgregg can remain profitable despite its high costs. If an hhgregg store has higher costs than a comparable Best Buy store, it can have greater profits only if the demand for its goods is higher. By having more experienced salespeople than its competitors, hhgregg has attracted more consumers. The higher demand from these consumers must be enough to offset hhgregg’s higher costs. Step 3: Draw graphs to illustrate your argument. Your Turn: Test your understanding by doing related problem 3.9 at the end of this chapter. MyEconLab

Comparing Perfect Competition and Monopolistic Competition 13.4 LEARNING OBJECTIVE Compare the efficiency of monopolistic competition and perfect competition.

Monopolistic competition and perfect competition share the characteristic that in long-run equilibrium, firms earn zero economic profits. However, there are two important differences between long-run equilibrium in the two markets: • Monopolistically competitive firms charge a price greater than marginal cost. • Monopolistically competitive firms do not produce at minimum average total cost.

Excess Capacity under Monopolistic Competition Figure 13.6 (1 of 2) Comparing Long-Run Equilibrium under Perfect Competition and Monopolistic Competition In panel (a), a perfectly competitive firm in long-run equilibrium produces at QPC, where price equals marginal cost, and average total cost is at a minimum. The perfectly competitive firm is both allocatively efficient and productively efficient.

Excess Capacity under Monopolistic Competition Figure 13.6 (2 of 2) Comparing Long-Run Equilibrium under Perfect Competition and Monopolistic Competition In panel (b), a monopolistically competitive firm produces at QMC, where price is greater than marginal cost, and average total cost is not at a minimum. As a result, the monopolistically competitive firm is neither allocatively efficient nor productively efficient. The monopolistically competitive firm has excess capacity equal to the difference between its profit-maximizing level of output and the productively efficient level of output.

Is Monopolistic Competition Inefficient? In Chapter 12, we discussed productive efficiency and allocative efficiency. Productive efficiency refers to the situation where a good is produced at the lowest possible cost. Allocative efficiency refers to the situation where every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Economists have debated whether monopolistically competitive markets being neither productively nor allocatively efficient results in a significant loss of well-being to society in these markets compared with perfectly competitive markets. How Consumers Benefit from Monopolistic Competition The perfectly competitive firm is selling a good or service identical to those being sold by its competitors. A key point to remember is that firms differentiate their products to appeal to consumers. The success of these product differentiation strategies indicates that some consumers find these products preferable to the alternatives. Consumers, therefore, are better off than they would have been had these companies not differentiated their products.

Making the Connection Netflix: Differentiated Enough to Survive? When Reed Hastings decided to start Netflix in 1997, the company was an immediate success. By 2011, Netflix had more than 25 million subscribers and profits of more than $150 million. But Netflix has many competitors. In the DVD rental business, Netflix had advantages that prevented Wal- Mart and Blockbuster and other firms from entering. By 2011, Netflix had more than 25 million subscribers and profits of more than $150 million. But Netflix may not have similar advantages in the business of streaming movies. Many other firms with large selections of movie and television programs have been entering the market. In late 2011, Netflix announced that it expected to suffer losses for a period during 2012 before returning to profitability. It remains to be seen whether Netflix can regain its profitability in the face of intense competition. Your Turn: Test your understanding by doing related problem 4.8 at the end of this chapter. MyEconLab

How Marketing Differentiates Products 13.5 LEARNING OBJECTIVE Define marketing and explain how firms use marketing to differentiate their products.

Advertising Defending a Brand Name Marketing All the activities necessary for a firm to sell a product to a consumer. Brand management The actions of a firm intended to maintain the differentiation of a product over time. Advertising If the increase in revenue that results from advertising is greater than the increase in costs, the firm’s profits will rise. Defending a Brand Name A firm can apply for a trademark, which grants legal protection against other firms using its product’s name. Legally enforcing trademarks can be difficult. U.S. firms often find it difficult to enforce their trademarks in the courts of some foreign countries,

What Makes a Firm Successful? 13.6 LEARNING OBJECTIVE Identify the key factors that determine a firm’s success.

A firm’s ability to differentiate its product and to produce it at a lower average cost than competing firms creates value for its customers. Some factors that affect a firm’s profitability are not directly under the firm’s control. Certain factors will affect all the firms in a market. Figure 13.7 What Makes a Firm Successful? The factors under a firm’s control—the ability to differentiate its product and the ability to produce it at lower cost—combine with the factors beyond its control to determine the firm’s profitability.

Making the Connection Is Being the First Firm in the Market a Key to Success? Some business analysts argue that the first firm to enter a market can have important first-mover advantages. By being the first to sell a particular good, a firm may find its name closely associated with the good in the public’s mind. Surprisingly, though, recent research has shown that the first firm to enter a market often does not have a long-lived advantage over later entrants. The Reynolds International Pen Company was replaced by Bic; Apple’s iPod was not the first digital music player; and Hewlett- Packard, which currently dominates the laser printer market was preceded by its inventor, Xerox. The same can be said for disposable diapers, and web browsers. In all these cases, the firms that were first to introduce a product ultimately lost out to latecomers who did a better job of providing consumers with products that were more reliable, less expensive, more convenient, or otherwise provided greater value. Although not first to market, Bic ultimately was more successful than the firm that pioneered ballpoint pens. Your Turn: Test your understanding by doing related problem 6.6 at the end of this chapter. MyEconLab

Economics in Your Life Opening Your Own Restaurant At the beginning of the chapter, we asked you to think about how successful you are likely to be in opening an Italian restaurant in your hometown. As you learned in this chapter, if your restaurant is successful, other people are likely to open competing restaurants. In a monopolistically competitive market, free entry will reduce prices and lead to zero economic profits in the long run. In addition to lowering prices, competition benefits consumers by leading firms to offer somewhat different versions of the same product; for example, two Italian restaurants will rarely be exactly alike.

Starbucks Expands Into Juice Business AN INSIDE LOOK Starbucks Expands Into Juice Business Figure 1 Figure 2 A new chain with short-run economic profit. The effect of entry on price, quantity, and profit.