1. Monopolistic Competition The best (worst) of both worlds?

2. Objectives Explain the characteristics of monopolistic competition. Explain the nature of profit for a monopolistically competitive firm. Compare MC to PC. Evaluate the role of advertising in MC. Create and analyze the MC graph.

3. Characteristics of Monopolistic Competition Many firms selling competitive products –Each firm has a small market share –Firms are competitive and do not collude –Firms are independent of each other Products are heterogeneous (differentiation) Easy (not perfectly free) entry and exit –Chiefly due to larger start-up costs

4. A little more about Differentiation Firms in MC will work very hard to make their product different from their competitors. –Product attributes –Customer service –Location –Branding and packaging –Advertising Because each firm produces a product that they are monopolistic over, the firm faces a downsloping demand curve.

5. Market Concentration When attempting to determine the nature of a market (competitive vs. monopolistic), economists examine the concentration of control by the firms in the industry. Two measures: –Concentration Ratios – the percentage of total output produced by the industry’s four largest firms. Monopoly – 100% Perfect Competition – 0% (or very close) Monopolistic competition - 40% or lower Oligopoly – 40% or higher –Herfindahl Index – the sum of every firm’s percentage market share squared (%S 1 2 + %S 2 2 + %S 3 2 + …) In perfect competition, HI would be around 0 (0 2 + 0 2 + 0 2 …= 0) In monopoly, HI would be 10,000 (100 2 = 10,000) In monopolistic competition, HI would be between 1,000 and 1,800 according to most economists In oligopoly, HI would be between 1,800 and 10,000

6. And now, the graph! D = AR MR ATC MC Q MC P Profit

7. The Long Run D = AR MR ATC MC Q MC P Profit Zero Economic Profit Excess Capacity P > MC

8. MC is not efficient Productive Inefficiency is smaller than in monopoly, but it is still inefficient. –In Monopolistic Competition, producers will experience excess capacity. They do not produce the quantity that results in the lowest per-unit cost (where MC=ATC) because of overcrowding in the market. This is a sign of productive inefficiency. Allocative Inefficiency is also present, but at less of a degree than in monopoly. –The price charged is above the marginal cost. In turn, resources are not allocated efficiently Draw a long-run MC firm vs. a long-run PC firm.

9. What can be done? Most economists agree that Monopolistic Competition is not efficient. Many economists believe that attempting to regulate these firms would be more harmful than good. Consider the cost of determining where MC=P. Consider the number of monopolistically competitive firms… The overall calculus is that regulation is generally undesired because it would be more burdensome to society than the allocative inefficiency produced by the firms.

10. The Issue of Advertising Firms that sell highly differentiated products will spend 10-20% of revenue on advertising. In the US, about $250 billion is spent every year to advertise. PRO’s: Advertising increases public knowledge and awareness, which allows consumers to make more informed choices, increases competition. CON’s: Advertising is mostly psychological, not informational, influences desires artificially, increases production costs, impedes competition by fueling false beliefs, increases ‘conspicuous consumption’ (Galbraith)

11. Modern Controversy: DTCA Direct-to-Consumer-Advertising exists today in the pharmaceutical industry. Controversy exists about the benefits of allowing these firms to advertise. Read the two handouts and write a 2 page pro/con analysis: –DTCA is beneficial and should be allowed. –DTCA is harmful and should be regulated/banned. –Your final analysis. Include graphs.