Monopolistic competition: : When you have completed your study of this chapter, you will be able to Monopolistic competition: Describe and identify monopolistic competition. Explain how a firm in monopolistic competition determines its output and price in the short run and the long run . Explain why advertising costs are high and wy firms use brand names in monopolistic competition. WHAT IS MONOPOLISTIC COMPETITION? : WHAT IS MONOPOLISTIC COMPETITION? Monopolistic competition is a market structure in which:
A large number of independent firms compete.
Each firm produces a differentiated product.
Firms compete on product quality, price, and marketing.
Firms are free to enter and exit. WHAT IS MONOPOLISTIC COMPETITION? : 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 WHAT IS MONOPOLISTIC COMPETITION? WHAT IS MONOPOLISTIC COMPETITION? : Product Differentation
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? WHAT IS MONOPOLISTIC COMPETITION? : Competing on Quality, Price, and Marketing
Design, reliability, service, ease of access to the product.
A downward sloping demand curve.
Advertising and packaging WHAT IS MONOPOLISTIC COMPETITION? WHAT IS MONOPOLISTIC COMPETITION? : Entry and Exit
No barriers to entry.
A firm cannot make economic profit in the long run. WHAT IS MONOPOLISTIC COMPETITION? OUTPUT AND PRICE DECISIONS : 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 on the next slide illustrates this decision. OUTPUT AND PRICE DECISIONS : 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 OUTPUT AND PRICE DECISIONS OUTPUT AND PRICE DECISIONS : 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 15.1 on the next slide illustrates a firm incurring a loss in the short run. OUTPUT AND PRICE DECISIONS : 1. Loss 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. OUTPUT AND PRICE DECISIONS 15.2 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 on the next slide illustrates long-run equilibrium. 15.2 OUTPUT AND PRICE DECISIONS 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 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
A markup of price over marginal cost OUTPUT AND PRICE DECISIONS 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.
A firm’s markup is the amount by which price exceeds marginal cost. OUTPUT AND PRICE DECISIONS OUTPUT AND PRICE DECISIONS : 1. The efficient scale is 100 pairs of jeans a day. OUTPUT AND PRICE DECISIONS 2. The quantity produced is less than the efficient scale and the firm has excess capacity. 3. Price exceeds marginal cost by the amount of the markup. OUTPUT AND PRICE DECISIONS : Is Monopolistic Competition Efficient
Efficiency requires marginal benefit to equal marginal cost.
In monopolistic competition, price exceeds marginal cost, which is an indicator of inefficiency.
Making the Relevant Comparison
Price exceeds marginal cost because of product differentiation. But product variety is valued.
The Bottom Line
The bottom line is ambiguous. But compared to the alternative, monopolistic competition looks efficient. OUTPUT AND PRICE DECISIONS DEVELOPMENT AND MARKETING : 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. DEVELOPMENT AND MARKETING : 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. DEVELOPMENT AND MARKETING : DEVELOPMENT AND MARKETING Advertising
Firms in monopolistic competition spend a large amount on advertising and packaging their products.
A large proportion of the prices that we pay cover the cost of selling a good.
Figure 15.5 on the next slide shows some estimates of marketing expenditures for some familiar markets. DEVELOPMENT AND MARKETING : 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 15.6 on the next slide illustrates the effects of selling costs on total cost. DEVELOPMENT AND MARKETING : DEVELOPMENT AND MARKETING 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. DEVELOPMENT AND MARKETING : DEVELOPMENT AND MARKETING 4. If advertising enables sales to increase from 25 pairs of jeans a day to 100 pairs a day, it lowers the average total cost from $60 a pair to $40 a pair. DEVELOPMENT AND MARKETING : 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 make demand more elastic.
The price and markup might fall. DEVELOPMENT AND MARKETING : DEVELOPMENT AND MARKETING With advertising, average total cost increases and the ATC curve becomes ATC1. Demand decreases and becomes more elastic. Profit maximizing output increases, the price falls, and the markup shrinks. DEVELOPMENT AND MARKETING : 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. DEVELOPMENT AND MARKETING : 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. DEVELOPMENT AND MARKETING : DEVELOPMENT AND MARKETING Efficiency of Advertising and Brand Names
Advertising and brand names that provide information about the quality of products so that buyers are able to make better choices 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.