1. MONOPOLISTIC COMPETITION Wk 8 2014

2. Syllabus Outcomes Covered Describe, using examples, the assumed characteristics of a monopolistic competition Explain that product differentiation leads to a small degree of monopoly power and therefore to a negatively sloping demand curve for the product. Explain, using a diagram, the short-run equilibrium output and pricing decisions of a profit maximizing (loss minimizing) firm in monopolistic competition, identifying the firm’s economic profit (or loss ) Explain, using diagrams, why in the long run a firm in monopolistic competition will make normal profit Distinguish between price competition and non-price competition Explain, using a diagram, why neither allocative efficiency nor productive efficiency are achieved by monopolistically competitive firms

3. Assumptions of the model 1. large no of firms - similar to PC 2. No barriers to entry/ exit - similar to PC 3. product differentiation – different to PC

4. Product differentiation Physical differences – shape, size, materials ( eg: clothing, books, furniture, food) Quality differences – eg: cars / electronics Location – establishing businesses in locations with easy access to customers / suppliers eg: hotels near airports, convenience stores near residential houses

5. Product differentiation Services – by offering special services with purchases eg: warranties and service on cars Product image – creating favourable image using advertising or celebrity endorsement – eg: Nestle, Nike

6. Product differentiation and Monopolistic demand and revenue curves Monopolistic market structures have elements of monopoly and perfect competition. Similar to P.C due to large no of firms and no barriers to entry /exit and Similar to monopoly due to product differentiation leading to higher P being set.

7. Examples Nike, Adidas, Puma are all part of many firms that make sports goods and shoes However each one of these firms has its own monopoly power related to its own products

8. Monopolistic Firms and Pricing Under P.C if firms raise P – it loses all sales Under Monopoly if firms raise P – it loses some sales Why???? Under Monopolistic firms if P rise – it loses more sales than monopoly – due to available substitutes but less than P.C due to product differentiation

9. Implications The way consumers behave in response to P rise under monopolistic competition has important implication for monopolistic firms because if firms can convince their consumers that their product is better than competitors then they will be able to gain monopoly power and charge higher P without losing sales.

10. Shape of D curve D D D Perfect Competition Monopoly Monopolistic

11. Role of P and Non P competition P competition: occurs when forms lowers P to attract customers away from rivals increasing its sales at expense of rivals Non P competition: occurs when firms use methods other than P to attract customers eg: advertising, quality, product support etc

12. Monopolistic firms invest in R& D and advertising to differentiate their product and improve it all the time because it gives them monopoly power. Rule: the more differentiated is a product from its substitute and the more successful are the advertising strategies the less elastic (or more inelastic) will D curve be and the greater is the firm monopoly power and profits gains earned in SR only

13. Profit maximization SR position identical to monopoly – only difference being PED of D curve facing these firms. D curve is flatter and more elastic than monopoly In SR firms can make either supernormal profits (+ve profits), normal profits(0 profits) or losses (-ve profits)

15. Firms apply rule of MR+MC to find profit max o/p extend to demand curve to find P Compare P with ATC to determine profits or losses per unit. In part (a) of 7.21 firms earn supernormal profits since P>ATC In part (b) P =ATC = normal profits In part (c) P< ATC = losses

16. Total profits or losses calculated by: Profits = Profits/Q X Q Losses = Losses/Q XQ

17. Profits in the LR Just like PC – in monopolistic firms in LR profits attracts new firms into industry and eliminate profits and firms earn normal profits Firms losing will exist industry and losses will be eliminated too back to normal profits

18. The Profitable Industry Firms making profits will attract new firms into the industry who will produce at lower prices and therefore more customers will attract customers away from existing (more expensive) firms. The impact on existing firms will be a shift in D curve to left and keeps shifting left with more firms entering until D is tangent(touches) ATC

21. The unprofitable industry Firms making losses lead firms to exit the industry. Customers therefore switch to the available substitutes which now experience rise in D The impact on the remaining firms will be a shift in D curve to the right. The process continues until all loses disappear when D is tangent(touches) ATC and firms earn normal profits. This occurs where MR = MC and P= ATC

23. Efficiency in Monopolistic competition Remembering the rule: Allocative efficiency when P=MC Productive efficiency when production takes place with at mini ATC

24. Efficiency in Monopolistic competition In the LR – monopolistic firms do not achieve allocative nor productive efficiency WHY?? Refer to diagram 7.22 slide 19.

25. Monopolistic competition and allocative efficiency Allocative efficiency is achieved where P = MC In LR monopolistic competition sells at P> MC therefore leads to under allocation of resources to the production of this good when society would have liked to have more output

26. Monopolistic competition and productive efficiency Production also occurs at higher than minimum ATC and therefore average costs are higher than what is optimal from society’s view.

27. CAPACITY OUTPUT A firm capacity is the output level where firm capacity is fully used Full capacity = output where ATC is minimum = Qc Profit max rule is MR = MC = Qe Qe < Qc

28. excess capacity = Capacity o/p – Profit max o/p This is the o/p lost when firm resources are underused because they produce o/p that does not minimise ATC If all firms produce at min ATC then same Q of o/p would be produced by less firms at less cost to society.

29. excess capacity Excess capacity is the result of product differentiation leading to a downward sloping demand curve for firms. Excess capacity is closely related to productive inefficiency due to production occurring at > mini ATC EG: restaurants with empty tables Retail shops with no customers Hotels with empty rooms

30. Product differentiation leads to product variety Therefore monopolistic competition may not be as inefficient as it is suggested Excess capacity is P customers pay having product variety