Monopolistic Competition Chapter 17 Monopolistic Competition 1

Objectives 1. Recognize imperfect competition among firms that sell differentiated products. 2. Understand the equalibrium characteristics of monopolistic competition. 3. Be able to evaluate the outcomes of monopolistically competitive market. 4. Understand the issues surrounding the effects of advertising. 5. Understand the debate over the role of brand names 1

The Spectrum of Market Structure Pure Competition Chapter 14 Pure Monopoly Chapter 15 Imperfect Competition Chapters 16 & 17 2

Imperfect Competition Two types of imperfectly competitive markets: Monopolistic Competition Many firms selling products that are similar but not identical (e.g. movies.) Oligopoly Only a few sellers, each offering a similar or identical product to the others (e.g. tennis balls.) 3

Monopolistic Competition Markets that have some features of competition and some features of monopoly. Attributes of Monopolistic Competition Many Sellers Product Differentiation Free Entry/Exit 4

Monopolistic Competition Monopolistic Competition is a market structure characterized by Many sellers Highly differentiated product Some control over price (pricemaker) Easy entrance and exit from the market

Attribute: Many Sellers Many firms competing for the same group of customers. Examples: books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc. 5

Attribute: Product Differentiation Alternative forms of differentiation: quality differences; additional service; location; and packaging. Toys or prizes with kid’s meals at fast-food restaurants. Results in firm facing a downward-sloping demand curve. Demand curve is highly, but not perfectly, elastic. 6

Attribute: Free Entry or Exit Firms can enter or exit the market without restriction. The number of firms in the market adjusts until economic profits are zero. 7

Monopolistic Competition... A market structure between perfectly competitive and monopolistic. Departs from the perfectly competitive because each seller offers a somewhat different product. Departs from a monopoly because there are many sellers, each of which is small compared to the market. 8

Short-Run Operation in Monopolistic Competition In the short-run, the monopolistically competitive firm: Follows a monopolist’s rule for profit-maximization. MR = MC Price > ATC Price < ATC Figure 17-1 9

Monopolistically Competitors in the Short-Run Price MC ATC P ATC Demand MR Quantity Q Profit Max. 10

Monopolistically Competitors in the Short-Run Price MC ATC P P>ATC Firm Makes Profit ATC Demand MR Quantity Q Profit Max. 11

Monopolistically Competitors in the Short-Run Price MC ATC ATC P Demand MR Quantity Q Loss Min. 12

Monopolistically Competitors in the Short-Run Price MC ATC ATC P P<ATC Firm Makes Losses Demand MR Quantity Q Loss Min. 13

Long-Run Operation in Monopolistic Competition If firms are making economic profits in the short-run, new firms are encouraged to enter the market. Results in the following: Increases the number of products offered Reduces demand faced by each firm Demand curves shift to the left, leading to More elastic demand. 14

Long-Run Operation in Monopolistic Competition Firms will enter and exit until the firms are making exactly zero economic profits. Two characteristics of monopolistic competition in the long-run: Price exceeds marginal cost Price equals average total cost Figure 17-2 15

A Monopolistic Competitor in the Long-Run Price MC ATC P=ATC D MR Quantity Q Profit Max. 16

Monopolistic Competition vs. Perfect Competition Two differences arise in the long-run between monopolistic competition and perfect competition: Excess Capacity Markup 17

Monopolistic Competition: Excess Capacity In perfect competition, firms produce at the efficient scale, i.e. the point where average total cost is minimized. Free entry in competitive markets drive firms to produce at the minimum of average total cost. Figure 17-3 18

The Competitive Firm’s Output in the Long-Run Price MC ATC P=MC P=MR=AR Quantity QEfficient Scale 19

Monopolistic Competition: Excess Capacity In monopolistic competition, the quantity of output is less than the “efficient scale” of perfect competition. A monopolistically competitive firm could increase the quantity it produces and lower the average total cost of production. 20

Monopolistically Competitive Output in the Long-Run Price MC ATC P MC Demand MR Quantity QProduced 21

Monopolistically Efficient Output in the Long-Run Price MC ATC P MC Demand MR Quantity Q Q Efficient Scale 22

Monopolistically Efficient Output in the Long-Run Price MC ATC P Excess Capacity MC Demand MR Quantity Q Q Efficient Scale 23

Monopolistic Competition: Mark Up Over Marginal Cost For a competitive firm, price equals marginal cost. For a monopolistically competitive firm, price exceeds marginal cost. Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistic competitive firm. 24

Monopolistically Competitive Output in the Long-Run Price MC ATC P Mark-Up MC Demand MR Quantity Q Q Efficient Scale 25

Monopolistic Competition and the Welfare of Society Inefficiencies may arise and include: The markup price over marginal cost Some consumers who value the good at more than the marginal cost of production will be deterred from buying it. Results in “deadweight loss” to society. 26

Monopolistic Competition and the Welfare of Society There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost. However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.

Monopolistic Competition and the Welfare of Society Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.

Monopolistic Competition and the Welfare of Society The number of firms in the market may not be the “ideal” one. There may be too much or too little entry. May lead to “externalities” of entry. Externalities of Entry: Product-Variety externality Business-Stealing externality 27

Monopolistic Competition and the Welfare of Society The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.

Monopolistic Competition and the Welfare of Society The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.

Quick Quiz! List the three key attributes of monopolistic competition. Draw and explain a diagram to show the long-run equilibrium in a monopolistically competitive market. 28

Monopolistic Competition: Advertising and Brand Names Product differentiation leads to advertising and brand names. Some critics of monopolistic competition contend that advertising and brand name exploit consumers and reduce competition. Defenders argue that advertising increases competition by offering a greater variety of products and prices. 29

Monopolistic Competition: Advertising Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue for advertising. As a whole (total economy) about 2 percent of total firm revenue, or over $100 billion a year is spent on advertising. 30

Advertising Critics of advertising argue that firms advertise in order to manipulate people’s tastes. They also argue that it impedes competition by implying that products are more different than they truly are.

Advertising Defenders argue that advertising provides information to consumers They also argue that advertising increases competition by offering a greater variety of products and prices. The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.

Monopolistic Competition: Advertising and Brand Names Brand Names may provide two benefits to consumers: Provide consumers information about quality when quality cannot be easily judged in advance of purchase. Give firms an incentive to maintain high quality. 31

Brand Names Critics argue that brand names cause consumers to perceive differences that do not really exist.

Summary Monopolistically competitive markets are characterized by many firms each producing a differentiated product with freedom of market entry. In equilibrium, monopolistically competitive markets produce with some excess capacity and each firm charges a price above marginal cost. 32

Summary The selling price of a monopolistic competitive market results in some deadweight losses and resource misallocation. Product differentiation leads to advertising and brand names. 33

Summary A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.

Summary Monopolistic competition does not have all of the desirable properties of perfect competition. There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost. The number of firms can be too large or too small.

Summary The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition.

Summary Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.