1 LECTURE #14: MICROECONOMICS CHAPTER 16 (Chapter 17 in 4 th Edition) Monopolistic Competition

2 Between Monopoly and Oligopoly  Oligopoly: a market structure in which only a few sellers offer similar or identical products  Economists measure domination using the concentration ratio.  CR = % of total market output supplied by four largest firms.  U.S. economy: most four-firm concentration ratios under 50%.  Monopolistic Competition: a market structure in which many firms sell products that are similar but not identical  Characteristics of Monopolistic Competition  Many Sellers  Product Differentiation  Free Entry

3 4 Types of Market Structure

4 Competition with Differentiated Products  The Monopolistically Competitive Firm (MCF) in the Short Run  Each firm faces a downward-sloping demand curve  Monopolistically competitive firm follows a monopolist's rule for maximizing profit  MCF chooses the output level MR = MC.  MCF sets price using demand curve to ensure consumers buy amount produced.

5 Competition with Differentiated Products If P > ATC, the firm is earning a profit. If P < ATC, the firm is earning a loss. If P = ATC, the firm is earning zero economic profit.

6 Competition with Differentiated Products  The Long-Run Equilibrium  When firms in monopolistic competition are making profit, new firms have an incentive to enter the market.  This increases the number of products from which consumers can choose.  Thus, the demand curve faced by each firm shifts to the left.  As the demand falls, these firms experience declining profit.  When firms in monopolistic competition are incurring losses, firms in the market will have an incentive to exit.  Consumers will have fewer products from which to choose.  Thus, the demand curve for each firm shifts to the right.  The losses of the remaining firms will fall.

7 Competition with Differentiated Products  Exit and entry process continues until all firms in the market are earning zero [economic] profit.  Demand and ATC curves are tangent to each other.  At tangency point, P = ATC and firm is earning zero economic profit.  Two characteristics of long-run equilibrium in a monopolistically competitive market  Price > MC  Price = ATC (due to the freedom of entry and exit).

8 Competition with Differentiated Products  Monopolistic versus Perfect Competition  Excess Capacity  Quantity of output produced is smaller than the quantity that minimizes average total cost (the efficient scale).  This implies that firms in monopolistic competition have excess capacity: Increase output and lower ATC of production.  Firms in perfect competition produce where P = ATC MIN,  Markup over Marginal Cost  In monopolistic competition, P > MC because firm has some market power.  In perfect competition, P = MC.

9 Competition with Differentiated Products Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-run equilibrium in a perfectly competitive market. Two differences are notable. (1) The perfectly competitive firm produces at the efficient scale, where average total cost is minimized. By contrast, the monopolistically competitive firm produces at less than the efficient scale. (2) Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition. Panel APanel B

10 Competition with Differentiated Products  Monopolistic Competition and the Welfare of Society  One source of inefficiency is the markup over marginal cost. This implies a deadweight loss.  Because there are so many firms in this type of market structure, regulating these firms would be difficult.  Also, forcing these firms to set P = MC would force them out of business.

11 Competition with Differentiated Products  There are also externalities associated with entry.  The product-variety externality occurs because as new firms enter, consumers get some consumer surplus from the introduction of a new product. (+)  The business-stealing externality occurs because as new firms enter, other firms lose customers and profit. (-)  Depending on which externality is larger, a monopolistically competitive market could have too few or too many products.

12 Advertising  The Debate over Advertising  The Critique of Advertising  Firms advertise to manipulate people's tastes.  Advertising impedes competition because it increases the perception of product differentiation and fosters brand loyalty.  This suggests that consumers will be less concerned with price differences among similar goods.  The Defense of Advertising  Firms use advertising to provide information to consumers.  Advertising fosters competition because it allows consumers to be better informed about all of the firms in the market.

13 Advertising  Advertising as a Signal of Quality  The willingness of a firm to spend a large amount of money on advertising may be a signal to consumers about the quality of the product being offered.  Note that the content of the advertisement is unimportant; what is important is that consumers know that the advertisements are expensive.

14 Advertising  Brand Names  In many markets there are two types of firms;  some firms sell products with widely recognized brand names  while others sell generic substitutes.  Critics of brand names argue that they cause consumers to perceive differences that do not really exist.  Economists defend brand names as a useful way to ensure that goods are of high quality.  Brand names provide consumers with information about quality when quality cannot be judged easily in advance of purchase.  Brand names give firms an incentive to maintain high quality, because firms have a financial stake in maintaining the reputation of their brand names.

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16 Homework  Questions for Review: 1, 4, 5, 7  Problems and Applications: 1, 3, 9, 10 Note: These are the exact same questions in Chapter 17 of the 4th edition.