Monopolistic Competition aka P S W L B t E rice eekers ith ow arriers o ntry

Characteristics Firms face low entry barriers Differentiated Products -they face a downward sloping demand curve -no Long Run Profits -Non-price Competition Price Taker Many Small Firms

Product Differentiation Price-searchers produce differentiated products – products that differ in design, dependability, location, ease of purchase, etc. Rival firms produce similar products (good substitutes) and therefore each firm confronts a highly elastic demand curve.

McHits or McMisses? Hulaburger - 1962 Filet o Fish - 1963 Strawberry shortcake - 1966 Big Mac - 1968 Big Mac Big N Tasty Big N Tasty w/ Cheese Quarter Pounder w/ Cheese Double Quarter Pounder w/ Cheese Crispy Chicken Chicken McGrill Filet-O-Fish Double Cheeseburger Cheeseburger Hamburger Chicken McNuggets (4) Chicken McNuggets (6) Chicken McNuggets (9) McSalad Shaker Chef Salad McSalad Shaker Garden Salad McSalad Shaker Grilled Chicken Caeser Salad Hot Apple Pie - 1968 Egg McMuffin - 1975 Drive Thru - 1975 Chicken McNuggets - 1983 Extra Value Meal - 1991 McLean Deluxe - 1991 Arch Deluxe - 1996 55-cent Special - 1997 Big Xtra - 1999 McRib, Sundaes and others ??

Homestyle Chicken Go Wrap Grilled Chicken Go Wrap Double Jr. Cheeseburger Deluxe 1/4 lb.* Single 1/2 lb.* Double with Cheese 3/4 lb.* Triple with Cheese Baconator® Jr. Hamburger Jr. Bacon Cheeseburger Jr. Cheeseburger Deluxe Jr. Cheeseburger Double Stack Deluxe Double Stack Triple Stack Fish Supreme Chicken Parmesan Sandwich 2/3 lb. Monster Thickburger® 1/3 lb. Low Carb Thickburger® Little Thick Cheeseburger 1/4 lb. Little Thickburger® 1/3 lb. Cheeseburger Chili Cheese Thickburger® 1/3 lb. Original Thickburger® 1/3 lb. Mushroom 'N' Swiss Thickburger® 1/3 lb. Bacon Cheese Thickburger® Big Chicken Fillet Sandwich Charbroiled Chicken Club Sandwich Charbroiled BBQ Chicken Sandwich Big Hot Ham 'N' Cheese™ Regular Hamburger Regular Cheeseburger Double Cheeseburger 5-Piece Chicken Breast Strips 7-Piece Chicken Breast Strips Big Shef Homestyle Chicken Go Wrap Grilled Chicken Go Wrap Spicy Chicken Go Wrap Crispy Chicken Deluxe Chicken Club Ultimate Chicken Grill Spicy Chicken Sandwich Homestyle Chicken Fillet 10-piece Chicken Nuggets Premium Fish Fillet Sandwich Crispy Chicken Sandwich

Homestyle Chicken Go Wrap Grilled Chicken Go Wrap Double Jr. Cheeseburger Deluxe 1/4 lb.* Single 1/2 lb.* Double with Cheese 3/4 lb.* Triple with Cheese Baconator® Jr. Hamburger Jr. Bacon Cheeseburger Jr. Cheeseburger Deluxe Jr. Cheeseburger Double Stack Deluxe Double Stack Triple Stack Homestyle Chicken Go Wrap Grilled Chicken Go Wrap Spicy Chicken Go Wrap Crispy Chicken Deluxe Chicken Club Ultimate Chicken Grill Spicy Chicken Sandwich Homestyle Chicken Fillet 10-piece Chicken Nuggets Premium Fish Fillet Sandwich Crispy Chicken Sandwich

Price and Output A profit-maximizing price searcher will expand output as long as marginal revenue exceeds marginal cost. Price will be lowered and output expanded until MR = MC The price charged by a price searcher will be greater than its marginal cost.

Marginal Revenue of a Price Searcher Initial price P1 & output q1. Total revenue (TR) = P1 * q1. Price Reduction in Total Revenue 1. As price falls from P1 to P2, output increases from q1 to q2, two conflicting influences on TR. Increase in Total Revenue P1 1. TR will rise because of an increase in the number of units sold (q2 - q1) * P2. P2 2. TR will decline [(P1 - P2) * q1] as q1 units once sold at the higher price (P1) are now sold at the lower price (P2). d Depending on the size of the shaded regions, total revenue may increase or decrease. MR Quantity/time q1 q2

Total Cost Marginal Cost Price (AR) Output Total Revenue Marginal Revenue Quantity ATC 50 80 90 110 140 180 230 290 360 440 530 30 10 20 40 50 60 70 80 90 110 90 70 50 30 10 -10 -30 -50 -70 1 2 3 4 5 6 7 8 9 10 ___ 80 45 37 35 36 38 41 49 53 1 2 3 4 5 6 7 8 9 10 120 110 100 90 80 70 60 50 40 30 20 110 200 270 320 350 360 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___

What do these curves look like? Marginal Cost Price (AR) Quantity Marginal Revenue ATC 30 10 20 40 50 60 70 80 90 110 90 70 50 30 10 -10 -30 -50 -70 80 45 37 35 36 38 41 49 53 1 2 3 4 5 6 7 8 9 10 120 110 100 90 80 70 60 50 40 30 20 How many to produce?

120 110 Cost 100 90 80 70 60 50 40 30 20 10 1 2 3 4 5 6 7 8 9 10 Output

120 110 Cost 100 MC 90 80 70 ATC 60 50 40 30 AR 20 MR 10 1 2 3 4 5 6 7 8 9 10 Output

1. Firm’s profit maximizing output? 2. What price will they charge? 3. Firm’s revenue? Total Cost? Total Profit? Price 4. How will things change in time? MC 24 ATC 10 8 D = AR MR 30 45 50 Quantity

Price and Output: Short Run Profit A monopolistic competitor maximizes profits by producing where MR = MC, at output level q Price MC Economic Profits and charges a price P along the demand curve for that output level. ATC P At q the average total cost is C. C What impact will economic profits have if this is a typical firm? d Because the price is greater than the average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] * q ) MR Quantity/time q

Profits and Losses in the Long Run Economic profits attract competition. New firms will expand supply and lower price. Individual demand curves will shift inward until the economic profits are eliminated. Economic losses cause firms to leave the market. Demand for the remaining firms’ output will rise until the losses have been eliminated, ending the incentive to exit. Firms can make either profits or losses in the short run, but only zero economic profit in the long run.

Price and Output: Long Run Because entry and exit are free, competition will eventually drive prices down to the level of ATC. Price MC When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored. ATC C = P P The price searcher establishes its output level where MC = MR. At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present. d MR Quantity/time q

Case 1: Prices rise Supply Profits and Losses Entry and Exit Profits Entry or Exit? Supply

SR Profits 1. Increased Demand, Price goes up 2. Firms enter, Demand faced by each firm decreases $6 ATC $5 MC $4 SR Profits $3 Demand $2 3. Price goes down $1 4. No LR Profits 10 20 30 40 50 60 Quantity

Case 2: Prices fall Supply Profits and Losses Entry and Exit Profits Entry or Exit? Supply

SR Losses 1. Demand falls, Price goes down 2. Firms leave, Demand faced by each firm increases $6 ATC $5 MC $4 Demand $3 SR Losses $2 3. Price goes up $1 4. No LR Losses 10 20 30 40 50 60 Quantity

Comparing Price Taker Markets LR equilibrium for both. P = ATC and there are no economic profits. In monopolistic competition, firms face a downward-sloping demand curve, its profit-maximizing price exceeds MC. In Monopolistic Competition, output is too small to minimize ATC in long-run equilibrium. Price Quantity/Time Pure Comp Mono comp MC MC ATC ATC P2 P1 d d MR q1 q2

Comparing Price Taker Markets Even though the two markets have the same cost structure, the price in the monopolistic competitor’s market is higher than that in the price-taker’s market ( P2 > P1 ). Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation). Price Quantity/Time Pure Comp Mono comp Price Price MC MC ATC ATC P2 d P1 d MR q1 q2

Allocative Efficiency Allocative efficiency is achieved when the most desired goods are produced at the lowest possible cost. The Minimum point on the ATC curve: ATC > marginal cost at the minimum point No allocative efficiency in Monopolistic Competition.

Price Discrimination Sellers may gain from price discrimination by charging: higher prices to groups of customers with more inelastic demand lower prices to groups of customers with more elastic demand Price discrimination generally leads to more output and additional gains from trade.

Net operating revenue ($300*100) = $30,000 The Economics of Price Discrimination Consider a hypothetical market for airline travel where the Marginal Cost per traveler is $100. If the airline charges all customers the same price, profits will be maximized where MC = MR. Here the airline charges everyone $400 and sells 100 seats. This generates Net Operating Revenue of $30,000 or (total revenues) $40,000 – (operating costs) $10,000. Price $700 Net operating revenue ($300*100) = $30,000 $600 $500 $400 $300 $200 MC $100 MR D 100 Quantity/time Single price

The Economics of Price Discrimination By charging higher prices to consumers with less elastic demand and lower prices to those with more elastic demand it will increase net operating revenue. If the airline charges $600 to business travelers (who have a highly inelastic demand) and $300 to other travelers (who have a more elastic demand), it can increase its Net Operating Revenue to $42,000. Price Price Net operating revenue from business travelers ($500*60) = $30,000 $700 Net operating revenue ($300*100) = $30,000 $700 Net operating revenue from all others ($200*60) = $12,000 $600 $600 $500 $500 $400 $400 $300 $300 $200 $200 MC MC $100 $100 MR D D 100 Quantity/time 60 120 Quantity/time Single price Price Discrim.

23 Questions

Right after you graduate, you get a job in production management and you are responsible for the entire company on weekends. Here are the costs of production for the company: Quantity Average Total Cost 500 $200 501 $201 Your current level of production is 500 units and all 500 have been ordered by regular customers. One weekend, the phone rings. It is a customer who wants to buy one unit of your product. This means increasing production to 501 units. The customer offers to buy it for $450. Should you accept the offer? What is the net change in the firm’s profit?

L o s s You’re Fired!!! Marginal Revenue = ?? Marginal Cost = ?? Quantity Average Total Cost 500 $200 501 $201 Total Cost (Q x ATC) $100,000 $100,701 $100,701 - $100,000 = $701 Marginal Cost = $701 Marginal Revenue = $450 Profit or Loss L o s s You’re Fired!!!

In a competitive price-searcher market, the firms will a. be able to choose their price, and the entry barriers into the market will be low. b. be able to choose their price, and the entry barriers into the market will be high. c. have to accept the market price for their product, and the entry barriers into the market will be low. d. have to accept the market price for their product, and the entry barriers into the market will be high. A profit-maximizing price searcher will expand output to the point where a. total revenue equals total cost. b. marginal revenue equals marginal cost. c. price equals average total cost. d. price equals marginal cost. In the long run, neither competitive price takers nor competitive price searchers will be able to earn economic profits because a. entry barriers into these markets are high, raising the costs of each firm. b. the government will dictate moderate prices for these firms. c. competition will force prices down to the level of per-unit production costs. d. marginal revenue is always less than marginal cost when barriers to entry are low. If a market is in long-run equilibrium, which of the following conditions will be present in a competitive price-taker market but absent from a competitive price-searcher market? a. P = ATC b. MR = MC c. P = MC d. MR < P

As long as a market is contestable, then even if it has only a few sellers, the a. threat of new firms will prevent the prices from rising above the competitive level. b. producers will be able to charge prices that are high enough to produce long-run economic profits. c. producers will not face new competition because the barriers to entry are high. d. market will never be expected to come close to the competitive result. If firms in a competitive price-searcher market are currently earning economic losses, then in the long run, a. new firms will enter the market, and the current firms will experience a decrease in demand for their products until zero economic profit is again restored. b. new firms will enter the market, and the current firms will experience an increase in demand for their products until zero economic profit is again restored. c. some existing firms will exit the market, and the remaining firms will experience an increase in demand for their products until zero economic profit is again restored. d. some existing firms will exit the market, and the remaining firms will experience a decrease in demand for their products until zero economic profit is again restored. Compared to the outcome when the firms are price takers, competitive price-searcher markets will result in a. a wider variety of products and higher prices. b. less product variety and higher prices. c. a wider variety of products and lower prices. d. less product variety and lower prices.

What price should this competitive price-searcher firm charge in order to maximize profits? $5 b. $7 c. $8 d. $10 d. $10 What is the maximum economic profit this firm depicted in Figure 2 will be able to earn? $0 b. $20 c. $30 d. $100 b. $20 If the cost and demand conditions of this competitive price-searcher firm, what will happen in the future? a. Firms will go out of business, and the market price will rise. b. The current market price will tend to persist into the future. c. New firms will enter the market, and demand facing this firm will decline. d. The firms in this industry probably will collude in order to increase their profitability.

The average variable cost (AVC) and average total cost (ATC) for a firm are indicated in Figure 3. If the marginal cost curve were constructed, at what output would it cross the AVC curve? a. 2 b 3 c. 4 d. 5 At what output would a properly constructed marginal cost curve cross the ATC curve? a. 3 b 4 c. 5 d. 6 Calculate the total cost of producing four units. a. $10 b. $15 c $60 d. $75 Calculate the total variable cost of producing three units. a. $10 b. $15 c. $30 d. $45

Which output level would be most closely associated with the point where diminishing marginal returns have begun? a 4 b. 5 c. 6 d. 8 Which output minimizes per-unit cost? a. 4 b. 6 c. 7 d 8 Which of the following is true? a. Firms in this industry begin to experience diminishing returns to their variable factors at output q1. b. Between q1 and q2, firms in this industry experience economies of scale. c Firms producing output rates less than q1 or more than q2 will find it difficult to survive. d. The largest firms in this industry have the lowest per-unit cost.

The graph illustrates a firm capable of earning economic profit. that is only able to break even when it maximizes profit. c taking economic losses. d. that should shut down immediately. When price rises from P2 to P3, the firm finds that a. marginal cost exceeds marginal revenue at a production level of Q2. b. if it produces at output level Q3 it will earn a positive profit. c expanding output to Q4 would leave the firm with losses. d. it could increase profits by lowering output from Q3 to Q2. When price falls from P3 to P1, the firm finds that fixed cost is higher at a production level of Q1 than it is at Q3. it should produce Q1 units of output. c. it should produce Q3 units of output. d it should shut down immediately.