1. Chapter 11 Monopolistic Competition and Product Differentiation

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-2 Assumptions of the Monopolistic Competition Model Free entry and exit in the long run  No barriers to entry Many firms, each one small relative to the size of the market  Firms will have limited market power. Each firm produces a differentiated product  Consumers view the goods as close substitutes, but not perfect substitutes.

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-3 Short-Run Profit Maximization for the Monopolistic Competitor Product differentiation creates a small amount of market power due to customer loyalty.  Even if the firm raises its price, it will still retain some of its customers.

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-4 Economic Efficiency Is a monopolistic competitive industry  Allocatively efficient?  Productively efficient?  Technologically efficient?

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-5 Figure 11.3 Short-Run Profits

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-6 Loss Minimization and the Shut-Down Point If demand decreases or costs increase, profits will fall.  If the demand curve just touches the ATC curve at the profit-maximizing level of output, the firm will earn normal economic profits.  If the demand curve just touches the AVC curve at the profit-maximizing level of output, the firm will be indifferent between operating and shutting down.

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-7 Figure 11.4 Minimizing Losses and Reaching the Shutdown Point

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-8 Monopolistic Competition in the Long Run In the short run, monopolistically competitive firms behave much like a monopolist. In the long run, however, monopolistic competition differs from monopoly because of free entry into the market.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-9 Firm Entry in Monopolistic Competition If firms in a monopolistically competitive market are earning positive economic profits, then new firms will enter the market.  Similar to perfect competition

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-10 Figure 11.5 Effects of New Entrants on the Demand for Cheesesteaks at John’s Roast Pork

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-11 Firm Entry in Monopolistic Competition An important difference between monopolistic competition and perfect competition is that price does not fall to the minimum point on the long-run average cost curve.  The firms are not efficient.

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-12 Summary of Monopolistic Competition Each firm maximizes profits by producing the output for which MR = MC.  Price is determined by the demand curve. Long-run entry implies that firms will be driven towards zero economic profits in the long run.  P = LAC Price will be greater than the minimum point of LAC. Firms have different demand and costs, leading to long-run turnover of firms.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-13 Allocative Efficiency For monopolistically competitive firms, the profit-maximizing level of output is less than that which minimizes LAC.  Monopolistically competitive firms are not as efficient as perfectly competitive firms.

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-14 Figure 11.6 The Long-Run Monopolistic Competition Equilibrium Versus the Perfect Competition Equilibrium

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-15 Excess Capacity As a result of underproduction at both the firm and industry level, monopolistically competitive firms are said to exhibit excess capacity.  Output could be increased without any firms earning losses.

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-16 The Benefits of Variety Is the reduction in efficiency associated with monopolistic competition bad for society? Not necessarily:  Because consumers value variety, the benefits of product differentiation may offset the costs of excess capacity.

17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-17 Table 11.1 Summary of Market Structure Characteristics for Perfect Competition, Monopolistic Competition, and Monopoly

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-18 Advertising: Information or Persuasion? Unlike perfectly competitive firms or monopolists, monopolistically competitive firms will advertise to inform customers about their product.

19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-19 Brand Identity and Brand Loyalty The goal of advertising is to create:  Brand Identity—the consumer’s ability to recognize a product and associate it with a specific name.  Brand Loyalty—a consumer’s willingness to remain with a specific product despite the existence of competing products. Makes demand less elastic

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-20 Types of Advertising Informational—increases consumers’ knowledge of important product characteristics and price. Persuasive—attempts to alter consumer tastes and preferences by using subjective information.

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-21 Figure 11.7 Effect of Advertising on the Demand for John’s Cheesesteaks

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-22 Advertising Product Characteristics Product characteristics will determine how a product is advertised.  Search goods have characteristics that can be described and easily verified by consumers. Advertised through informational advertising  Experience goods have to be consumed before a consumer can determine their characteristics. Advertised using persuasive advertising

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-23 Life Lessons Taste tests show that most consumers cannot tell the difference between colas.  Think twice before paying full price for a brand name soda.

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-24 Strategy and Policy Something old, something new, all in the same box.  Cereal manufacturers believed that changing the names of cereals might make people think they were not purchasing high-sugar content cereal.

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-25 Summary Monopolistic competition is defined as a large number of firms producing a differentiated product in a market with free entry. A monopolistically competitive firm maximizes profit by producing the level of output for which MR = MC.  Price is then determined by the demand curve.

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-26 Summary (cont’d) In the long run, because of free entry and exit, monopolistically competitive firms will earn zero economic profits. Monopolistically competitive firms are less efficient than perfectly competitive firms.  Excess capacity Product differentiation offsets some of the loss of efficiency.

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-27 Summary (cont’d) Firms use adverting to differentiate their product from competing products.  Informational  Persuasive