Monopolistic Competition CHAPTER 16

C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Describe and identify monopolistic competition. 2 Explain how a firm in monopolistic competition determines its output and price in the short run and the long run. 3 Explain why advertising costs are high and why firms use brand names in monopolistic competition.

16.1 WHAT IS MONOPOLISTIC COMPETITION? Monopolistic competition is a market structure in which A large number of firms compete. Each firm produces a differentiated product. Firms compete on price, product quality, and marketing. Firms are free to enter and exit.

 Large Number of Firms Like perfect competition, the market has a large number of firms. Three implications are Small market share No market dominance Collusion impossible 16.1 WHAT IS MONOPOLISTIC COMPETITION?

 Product Differentation Product differentiation is making a product that is slightly different from the products of competing firms. A differentiated product has close substitutes but it does not have perfect substitutes. When the price of one firm’s product rises, the quantity demanded of that firm’s product decreases WHAT IS MONOPOLISTIC COMPETITION?

 Competing on Quality, Price, and Marketing Quality Design, reliability, after-sales service, and buyer’s ease of access to the product. Price Because of product differentiation, the demand curve for the firms’ product is downward sloping. Marketing Advertising and packaging 16.1 WHAT IS MONOPOLISTIC COMPETITION?

 Entry and Exit No barriers to entry. So the firm cannot make economic profit in the long run.  Identifying Monopolistic Competition Two indexes: The four-firm concentration ratio The Herfindahl-Hirschman Index 16.1 WHAT IS MONOPOLISTIC COMPETITION?

The Four-Firm Concentration Ratio The four-firm concentration ratio i s the percentage of the value of sales accounted for by the four largest firms in the industry. The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly. A ratio that exceeds 60 percent is an indication of oligopoly. A ratio of less than 40 percent is an indication of a competitive market—monopolistic competition WHAT IS MONOPOLISTIC COMPETITION?

The Herfindahl-Hirschman Index The Herfindahl-Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms in a market. Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent. HHI = = 3,450 A market with an HHI less than 1,000 is regarded as competitive and between 1,000 and 1,800 is moderately competitive WHAT IS MONOPOLISTIC COMPETITION?

Limitations of Concentration Measures The two main limitations of concentration measures alone as determinants of market structure are their failure to take proper account of The geographical scope of a market Barriers to entry and firm turnover 16.1 WHAT IS MONOPOLISTIC COMPETITION?

16.2 OUTPUT AND PRICE DECISIONS How, given its costs and the demand for its jeans, does Tommy Hilfiger decide the quantity of jeans to produce and the price at which to sell them?  The Firm’s Profit-Maximizing Decision The firm in monopolistic competition makes its output and price decision just like a monopoly firm does. Figure 16.1 on the next slide illustrates this decision.

1. Profit is maximized when MR = MC. 3. The profit-maximizing price is $75 per pair. 4. The firm makes an economic profit of $6,250 a day. 2. The profit-maximizing output is 125 pairs of Tommy jeans per day. ATC is $25 per pair, so 16.2 OUTPUT AND PRICE DECISIONS

 Profit Maximizing Might Be Loss Minimizing Some firms in monopolistic competition have a tough time making a profit. A burst of entry into an industry can limit the demand for each firm’s own product. Figure 16.2 on the next slide illustrates a firm incurring a loss in the short run.

1. Loss is minimized when MC = MR. 3. The price is $40 per month, which is less than ATC. 4. The firm incurs an economic loss. 2. The loss-minimizing output is 40,000 customers and 16.2 OUTPUT AND PRICE DECISIONS

 Long Run: Zero Economic Profit Economic profit induces entry and economic loss induces exit, as in perfect competition. Entry decreases the demand for the product of each firm. Exit increases the demand for the product of each firm. In the long run, economic profit is competed away and firms earn normal profit. Figure 16.3 on the next slide illustrates long-run equilibrium OUTPUT AND PRICE DECISIONS

1. The output that maximizes profit is 75 pairs of Tommy jeans a day. 2. The price is $50 per pair. Average total cost is also $50 per pair. 3. Economic profit is zero OUTPUT AND PRICE DECISIONS

 Monopolistic Competition and Perfect Competition The two key differences between monopolistic competition and perfect competition are that in monopolistic competition, there is Excess capacity A markup of price over marginal cost 16.2 OUTPUT AND PRICE DECISIONS

Excess Capacity A firm has excess capacity if the quantity it produces is less that the quantity at which average total cost is a minimum. A firm’s efficient scale is the quantity of production at which average total cost is a minimum. Markup A firm’s markup is the amount by which price exceeds marginal cost OUTPUT AND PRICE DECISIONS

1. The efficient scale is 100 pairs of Tommy jeans a day. 2. The firm produces less than the efficient scale and has excess capacity. 3. Price exceeds 4. marginal cost by the amount of 5. the markup. 6. Deadweight loss arise OUTPUT AND PRICE DECISIONS

In perfect competition, 1. The efficient quantity is produced and 2. Price equals marginal cost OUTPUT AND PRICE DECISIONS

 Is Monopolistic Competition Efficient? Deadweight Loss Because price exceeds marginal cost, monopolistic competition creates deadweight loss—an indicator of inefficiency. Making the Relevant Comparison Price exceeds marginal cost because of product differentiation. But product variety is valued. The Bottom Line Product variety is both valued and costly. But compared to the alternative, monopolistic competition looks efficient OUTPUT AND PRICE DECISIONS

16.3 PRODUCT DEVELOPMENT AND MARKETING  Innovation and Product Development Wherever economic profits are earned, imitators emerge. To maintain economic profit, a firm must seek out new products. Cost Versus Benefit of Product Innovation The firm must balance the cost and benefit at the margin.

16.3 PRODUCT DEVELOPMENT AND MARKETING Efficiency and Product Innovation Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which equals the amount the consumer is willing to pay. The marginal benefit to the producer is the marginal revenue, which in equilibrium equals marginal cost. Because price exceeds marginal cost, product improvement is not pushed to its efficient level.

16.3 PRODUCT DEVELOPMENT AND MARKETING  Advertising Firms in monopolistic competition spend a large amount on advertising and packaging their products. Advertising Expenditures A large proportion of the prices that we pay cover the cost of selling a good. Eye On the U.S. Economy shows some estimates of marketing expenditures for some familiar markets.

16.3 PRODUCT DEVELOPMENT AND MARKETING  Selling Costs and Total Costs Advertising expenditures increase the costs of a monopolistically competitive firm above those of a perfectly competitive firm or a monopoly. Advertising costs are fixed costs. Advertising costs per unit decrease as production increases. Figure 16.5 on the next slide illustrates the effects of selling costs on total cost.

1. When advertising costs are added to 2. The average total cost of production, 3. Average total cost increases by a greater amount at small outputs than at large outputs PRODUCT DEVELOPMENT AND MARKETING

4. If advertising enables sales to increase from 25 pairs of jeans a day to 100 pairs a day, and the average total cost falls from $60 a pair to $40 a pair PRODUCT DEVELOPMENT AND MARKETING

Selling Costs and Demand Advertising and other selling efforts change the demand for a firm’s product. The effects are complex: A firm’s own advertising increases the demand for its product. Advertising by all firms might decrease the demand for any one firm’s product and might make demand more elastic. The price and markup might fall.

Figure 16.6 shows the possible effect of advertising. With no advertising, demand is low but the markup is large PRODUCT DEVELOPMENT AND MARKETING

With advertising, average total cost increases and the ATC curve becomes ATC 1. If all firms advertise, demand decreases and becomes more elastic. Profit-maximizing output increases, the price falls, and the markup shrinks PRODUCT DEVELOPMENT AND MARKETING

 Using Advertising to Signal Quality Some advertising is very costly and has almost no information content about the item being advertised. Such advertising is used to signal high quality. A signal is an action taken by an informed person or firm to send a message to uninformed people. Signaling works because it is profitable to signal high quality and deliver it but unprofitable to signal a high quality product and not deliver it.

16.3 PRODUCT DEVELOPMENT AND MARKETING  Brand Names Brand names are also used to provide information about the quality of a product. It is costly to establish a widely recognized brand name. Like costly advertising, a brand name signals high quality. Brand names work because it is unprofitable to incur the cost of creating a brand name and then deliver a low quality product.

16.3 PRODUCT DEVELOPMENT AND MARKETING  Efficiency of Advertising and Brand Names Advertising and brand names that provide information about the quality of products enable buyers to make better choices. Advertising and brand name can be efficient if the marginal cost of the information equals its marginal benefit. The final verdict on the efficiency of monopolistic competition is ambiguous.