ANTHONY PATRICK O’BRIEN R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN FIFTH EDITION © 2015 Pearson Education, Inc.

Monopolistic Competition: The Competitive Model in a More Realistic Setting

Perfect Competition vs. Monopolistic Competition The perfectly competitive markets in the previous chapter had the following three features: Many firms Firms sell identical products No barriers to entry to new firms entering the industry The first two features implied a horizontal demand curve for individual firms, while the third implied zero long-run profit. Monopolistically competitive firms share features 1. and 3.; but their products are not identical to their competitors’. So we expect monopolistically competitive firms to have zero long-run profit, but not to face a horizontal demand curve.

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

Monopolistic Competition Monopolistic competition is a market structure in which barriers to entry are low and many firms compete by selling similar, but not identical, products. The key feature here is that the products that monopolistically competitive firms sell are differentiated from one another in some way. Example: Starbucks sells coffee, and competes in the coffee market against other firms selling coffee. But Starbucks’ coffee is not identical to the coffee that other firms sell.

The Demand Curve for a Monopolistically Competitive Firm Starbucks sells caffè lattes; while other firms sell caffè lattes also, some people have a preference for the ones that Starbucks sells. If Starbucks raises the price of its caffè lattes, it will lose some, but not all, of its customers. Therefore Starbucks faces a downward- sloping demand curve for caffè lattes. 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 coffeehouse faces a downward-sloping demand curve. Figure 13.1 The downward-sloping demand for caffè lattes at a Starbucks

Marginal Revenue When Demand Is Downward-Sloping 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 5.50 10.00 13.50 16.00 17.50 18.00 ― $5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 ― $5.50 4.50 3.50 2.50 1.50 0.50 –0.50 –1.50 –2.50 –3.50 The first two columns show the demand schedule for Starbucks. Total revenue increases initially, then decreases; Starbucks has to lower the price in order to sell additional caffè lattes. Hence marginal revenue is initially positive, then negative. Table 13.1 Demand and marginal revenue at a Starbucks

How a Price Cut Affects Firm Revenue When Starbucks reduces the price of a caffè latte, it can sell more output. Its revenue increases because of the additional sale (at the new price); this is the output effect of the price reduction. If a 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). Figure 13.2 How a price cut affects a firm’s revenue But its revenue decreases also. In order to sell the additional caffè latte, it must reduce the price on all cups it will sell. The loss in revenue on the 5 cups it would have sold anyway is the price effect of the price reduction.

Marginal Revenue Starbucks’ marginal revenue for selling the additional caffè latte is equal to the green area minus the pink area: the output effect minus the price effect. Since the output effect is just equal to the price, marginal revenue is lower than price. Figure 13.2 How a price cut affects a firm’s revenue For any firm with a downward-sloping demand curve, the marginal revenue curve must therefore be below the demand curve.

Demand and Marginal Revenue Curves The graph shows the Starbucks’ demand and marginal revenue curves for caffè lattes. After the 6th caffè latte, reducing the price in order to increase sales results in revenue decreasing (negative marginal revenue); the output effect (equal to the height of the demand curve) can no longer offset the price effect (the vertical difference between demand and marginal revenue curves). 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. Figure 13.3 The demand and marginal revenue curves for a monopolistically competitive firm

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

Profit Maximization Just like a perfectly competitive firm, a monopolistically competitive firm should not simply try to maximize revenue. Each additional unit of output incurs some marginal cost. Profit maximization requires producing until the marginal revenue from the last unit is just equal to the marginal cost: MC = MR. This same rule holds for all firms that can marginally adjust their output.

Profit Maximization Using a Table The 1st, 2nd, 3rd, and 4th caffè lattes each increase profit: MC < MR. The 5th does not alter profit: MC = MR. The 6th and subsequent caffè lattes decrease profit: MC > MR. Figure 13.4 Maximizing profit in a monopolistically competitive market

Profit Maximization Using Graphs 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, selling the fifth caffè latte—point A in panel (a)—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, for this Starbucks profit equals $1 * 5 = $5.00. Starbucks sells caffè lattes up until MC = MR. This selects the profit-maximizing quantity. Then the demand curve shows the price, and the ATC curve shows the average cost. Since Profit = (P – ATC) x Q, we can show profit on the graph with the green rectangle. Figure 13.4 Maximizing profit in a monopolistically competitive market

Identifying Profit Graphically Be careful to perform these steps in the correct order: Use MC=MR to identify the profit-maximizing quantity. Draw a vertical line at that quantity. The vertical line will hit the demand curve: this is the price. The vertical line will also hit the ATC curve: this is the average cost. Figure 13.4b Maximizing profit in a monopolistically competitive market The difference between price and average cost is the profit (or loss) per unit. Show the profit or loss with the rectangle with height (P – ATC) and length (Q* – 0), where Q* is the optimal quantity.

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

How the Entry of New Firms Affects Profits of Existing Firms 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. Figure 13.5 How entry of new firms eliminates profits Suppose demand is relatively high, so that Starbucks can make a profit in the market for caffè lattes. This profit will attract new firms who will compete with Starbucks, reducing the demand for Starbucks’ caffè lattes. Demand falls until, in the long run, no profit can be made: P = ATC.

Monopolistic Competition: Short Run, Firm Making Profit Relationship between Price and Marginal Cost Relationship between Price and Average Total Cost Profit and Loss Short Run P > MC Short Run P > ATC Short Run Economic profit Table 13.2a The short run and the long run for a monopolistically competitive firm In the short run, a monopolistically competitive firm might make a profit or a loss. The situation where the firm is making a profit is above. Notice that there are quantities for which demand (price) is above ATC; this is what allows the firm to make a profit.

Monopolistic Competition: Short Run, Firm Making Loss Relationship between Price and Marginal Cost Relationship between Price and Average Total Cost Profit and Loss Short Run P > MC Short Run P < ATC Short Run Economic loss Table 13.2b The short run and the long run for a monopolistically competitive firm Now the firm is making a loss. Notice that there is now no quantity for which demand (price) is above ATC; this firm must make a (short-run, economic) loss, no matter what quantity it chooses.

Monopolistic Competition: Long Run, Firm Breaking Even Relationship between Price and Marginal Cost Relationship between Price and Average Total Cost Profit and Loss Long Run P > MC Long Run P = ATC Long Run Zero economic profit Table 13.2c The short run and the long run for a monopolistically competitive firm In the long run, the firm must break even. Notice that the ATC curve is just tangent to the demand curve. The best the firm can do is to produce that quantity. There is no quantity at which the firm can make a profit; the ATC curve is never below the demand curve.

Zero Profit in the Long Run? Our model of monopolistic competition predicts that firms will earn zero profit in the long run. However firms need not passively accept this long-run outcome. They could: Innovate so that their costs are lower than other firms, or Convince their customers that their product/experience is better than that of other firms, either by actually making it better in some unique way, or making customers perceive that it is better, perhaps through advertising. Think of the long-run as “the direction of trend”; demand will continue to fall to the zero (economic) profit level, unless the firm is able to do something about it.

The Rise and Decline and Rise of Starbucks From the mid-1990s to the mid-2000s, Starbucks achieved strong profits by differentiating its product and experience from other coffeehouses. As other firms started to mimic its experience, Starbucks’ profitability went down. By 2013, Starbucks had engineered a turnaround, with innovations like wi-fi, customization of drinks, a loyalty program, smartphone-based payments, overseas expansion, and higher-quality drinks. But like all monopolistically competitive firms, Starbucks will have to continue to innovate, or the long-run outcome of zero economic profit will catch up to it.

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

Is Monopolistic Competition Efficient? Last chapter we learned that perfectly competitive firms achieved productive and allocative efficiency. Productive efficiency refers to producing items at the lowest possible cost. Allocative efficiency refers to producing all goods up to the point where the marginal benefit to consumers is just equal to the marginal cost to firms. Monopolistic competition results in neither productive nor allocative efficiency.

Efficiency of Perfectly Competitive Firms Figure 13.6a 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. 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. 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.

Inefficiency of Monopolistically Competitive Firms Figure 13.6a&b Comparing long-run equilibrium under perfect competition and monopolistic competition Monopolistically competitive firms in panel (b) produce the quantity where MC=MR. The marginal benefit to consumers is given by the demand curve, so MC≠MB: not allocatively efficient. And average cost is above its minimum point: not productively efficient.

Is Monopolistic Competition Bad for Consumers? The lack of efficiency suggests that monopolistic competition is a bad situation for consumers. But consumers might benefit from the product differentiation. Example: If you were buying a car, would you prefer one Produced and sold at the lowest possible cost, but not well-suited to your tastes and preferences; or Produced and sold at a higher cost, but designed to attract you to purchasing it? Many consumers are willing to accept a higher price for a differentiated product. So monopolistic competition is not necessarily bad for consumers.

Peter Thiel and Monopolistic Competition Peter Thiel is a billionaire entrepreneur: a co-founder of PayPal, and an early investor in LinkedIn, Zynga, and Facebook. Thiel recommends entrepreneurs focus on the monopoly part of monopolistic competition; there are economic profits to be made in the short run if you can “own a market”; according to Thiel, by: Having brand, scale, or cost advantages Taking advantage of network effects Having proprietary technology Thiel’s latest project: investing in NJOY, a firm making e-cigarettes.

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

Marketing and Product Differentiation Making customers believe that your product is worthwhile and different from those of other firms is not a trivial exercise. It typically involves some degree of marketing. Marketing: All the activities necessary for a firm to sell a product to a consumer. Once a firm manages to differentiate its product, it must continue to do so, or risk heading toward the long-run outcome of zero economic profit. The process of doing this is known as brand management. Brand management: The actions of a firm intended to maintain the differentiation of a product over time.

Advertising Advertising is a critical element of marketing for monopolistically competitive firms. By advertising effectively, firms can increase demand for their products. But they can also use advertising to differentiate their products: effectively making the demand curve more inelastic. This allows firms to charge a higher price and earn more short-run profit.

Defending a Brand Name Marketing experts and psychologists agree: a critical aspect of marketing is creating a brand name for your product. A successful brand name can help to maintain product differentiation, and delay the ability of other firms to compete away your profits. But firms must always try to maintain the perception of their product as better than others, making sure that, for example: A highly-successful name like Coke, Xerox, or Band-Aid is uniquely associated to that product, and not to generic products, Other firms don’t illegally use their brand name, and Franchisees and others legally allowed to use their brand name maintain the level of quality and service you expect.

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

What Makes a Firm Successful? 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. 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. 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. Source: Adapted from Figure 9.2 in David Besanko, David Dranove, Mark Shanley, and Scott Schaefer, The Economics of Strategy, 6th edition, New York: John Wiley & Sons, Inc., 2012, p. 295. Figure 13.7 What makes a firm successful?

Is Being the First Firm in the Market a Key to Success? By being the first to sell a particular good, a firm may gain a first-mover advantage, finding 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 the end, providing customers with good products at a low price is probably the best way to ensure success.

Common Misconceptions to Avoid Monopolistically competitive firms produce the quantity where MC = MR, not the lowest possible average cost. Use the marginal cost and marginal revenue curves to determine quantity; then use the demand and average total cost curves to determine price, cost, and profit or loss. Although our model predicts zero economic profit in the long run, the long run might be delayed indefinitely by innovative firms.