1 C H A P T E R 11 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Entry and Monopolistic Competition

2 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  In the absence of substantial economies of scale, it is possible for additional firms to enter the market, driving down prices and profit.  Output decisions are based on the marginal principle: Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

3 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  When a second firm enters the market, the monopoly’s demand and marginal revenue curves shift inward.  The firm’s price and output level will have to be adjusted in order to follow the marginal principle.

4 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  Given the structures of cost and revenue, the monopoly satisfies the marginal principle by producing and selling 300 toothbrushes at $2 each.  After entry, each of two firms produces 200 units and charges $1.85 per unit.

5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  Before entry, the monopoly produces 300 units, at a cost per unit of $0.90 per toothbrush.  After entry, each of two firms produces 200 units at an average cost of $1.00.

6 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  There are three reasons why profit decreases for the individual firm after entry of a second firm: Lower price Lower quantity sold Higher average cost of production Summary:

7 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Characteristics of Monopolistic Competition Characteristics of Monopolistic Competition:  Many firms  Differentiated product  No artificial barriers to entry

8 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Meaning of “Monopolistic Competition”  Each firm is monopolistic because it sells a unique product.  The availability of close substitutes makes the firm’s demand very price elastic.  Each firm is a competitive because it sells a product that is a close but not a perfect substitute for the products sold by other firms in the market.

9 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Product Differentiation  Physical characteristics  Location  Services  Aura or image Firms may differentiate their product in several ways:

10 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Short-run and Long-run Equilibrium Under Monopolistic Competition  As firms enter, each firm’s demand curve shifts to the left, decreasing market price, decreasing the quantity produced per firm, and increasing the average cost of production.  As long as there is profit to be made, more and more firms will enter the market.  Entry will stop once the economic profit of each existing firm reaches zero. In the long run, revenue will be just enough to cover all costs, including the opportunity cost of all inputs, but not enough to cause additional firms to enter.

11 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Long-run Equilibrium Under Monopolistic Competition  In this example, the marginal principle is satisfied at 55 thousand toothbrushes per minute, selling at a price of $1.35. The cost of producing each toothbrush is also $1.35. Economic profit equals zero.

12 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Trade-offs with Monopolistic Competition MonopolyMonopolistic Competition

13 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Trade-offs with Monopolistic Competition Monopolistic competition brings good news and bad news relative to the monopoly outcome:  Good news: lower price and greater variety  Bad news: higher average cost

14 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Spatial Differentiation and Competition  There are many spatially differentiated products. When firms differentiate their products by offering them at more locations, the benefit of having more firms is that consumers travel shorter distances to get the product.  With a single seller, the average cost of production would be lower, but prices would be higher, and consumers would spend more time traveling to buy the product.