Monopolistic Competition Chapter 13 Pure competition and pure monopoly are the exceptions, not the rule, in the U.S. economy. This chapter examines the first of two market structures that fall between the extremes, monopolistic competition. This market type contains a considerable amount of competition mixed with a small dose of monopoly power. First, monopolistic competition is defined, listing important characteristics, typical examples, and efficiency outcomes. The Last Word shows how increases in the minimum wage are putting mom and pop restaurants out of business while having little affect on the big chain restaurant. Monopolistic Competition

Monopolistic Competition Relatively large number of sellers Product differentiation Easy entry and exit Nonprice competition like advertising 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. Product differentiation and advertising are ways that firms can compete other than by offering the lowest price. LO1

Monopolistically Competitive Industries Industry concentration Measured by 4-firm concentration ratio Percentage of sales by 4 largest firms Herfindahl index Sum of squared market shares output of four largest firms total output in the industry 4-firm CR = 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. HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2 LO1

Low Concentration Industries (1) Industry (2) 4-Firm Concentration Ratio (3) Herfindahl Index Jewelry 32 550 Ready-mix concrete 14 89 Plastic pipe 31 303 Sawmills 93 Plastic bags 28 320 Textile bags 13 Asphalt paving 25 230 Wood pallets 12 55 Bolts, nuts, and rivets 23 198 Stone products 56 Women’s dresses 22 236 Textile machinery 10 58 Wood trusses 21 158 Metal stamping 52 Curtains and draperies 20 172 Signs 9 36 Metal windows and doors 17 143 Sheet metal work 8 29 Quick printing 108 Retail bakeries 5 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, 2012

Price and Output in Monopolistic Competition Demand is highly elastic Short run profit or loss Produce where MR = MC Long run only a normal profit Entry and exit 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 a later 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 relatively free entry and exit into and out of the industry. LO2

The Short Run: Profit Price and costs Quantity ATC MC P1 A1 Economic 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 = MC MR Q1 Quantity LO2

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

Long Run: Only a Normal Profit MC ATC P3= A3 Price and costs D3 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 and long run equilibrium is established. MR = MC MR Q3 Quantity LO2

Monopolistic Competition and Efficiency Monopolistic competition inefficient P > min ATC is condition for productive inefficiency P > MC is condition for allocative inefficiency Excess capacity Productive efficiency means that the firm is producing in the least costly way and is found when P = minimum ATC. Allocative efficiency means that the firm is producing the right amount of product and is found when P = MC. Neither condition is met in monopolistic competition. As we examine the industry, we will find that it is inefficient. There is excess capacity in the industry which means that the plant and equipment are underutilized because firms are producing below minimum ATC output. LO3

Monopolistic Competition is Inefficient Quantity Price and costs MC MR D3 ATC Q3 P3= A3 MR = MC A4 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. There is 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 LO3

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. The product variety that is found in monopolistic competition helps compensate for its failure to achieve economic efficiency. Consumers have a wider array of products to choose from and, presumably, they have better quality products to choose from as well. Product differentiation is at the heart of the trade-off between consumer choice and productive efficiency. The greater the number of choices the consumer has, the greater the excess capacity problem. LO4

More McRestaurants Higher minimum wage favors big hamburger chains Big chain restaurants are capital intensive so an increase in the minimum wage doesn’t affect them much Mom and Pop restaurants are labor intensive so an increase in the minimum wage can put them out of business Politicians and the public need to be aware of consequences of policy In the monopolistically competitive restaurant market, higher wages favor big chain restaurants over small mom and pop operations. Restaurants are monopolistic competitors through their unique location, menu items, décor, speed of service, and even whether or not they have a drive through. McDonald’s has a huge amount of capital in their restaurants with lots of specialized equipment and technology. While the small hamburger stand will likely have only the bare minimum in cooking equipment and probably no technology. The small operation has to make up the difference by using more labor. That is why the small operation is greatly affected by increases in the minimum wage while the large chain restaurant is relatively unscathed. This is an unintended consequence of a law that was meant to help low wage workers.