Monopolistic CompetitionMonopolistic CompetitionChapter 26Chapter 26

Key Questions for this chapter include:

• What are the unique features of monopolistic competition?

• How are the market outcomes affected by this market structure?

• What are the long-run consequences of different market structures?

Structure• “many” firms in the industry.

• many firms produce similar goods or services but each maintains some independent control of its own price.

• “Many” is somewhere between the “few” of oligopolies or the “hordes” that characterize perfect competition.

• Low barriers to entry

Low Concentration• Low concentration ratios are common in

monopolistic competition.– Concentration Ratio – The proportion of total

industry output produced by the largest firms (usually the four largest).

• Examples of monopolistic competition include banks, radio stations, health spas, apparel stores, and convenience stores, fast foods, and shoe stores,

• What about cellular industry?

• Market Power

• Each producer in monopolistic competition is large enough to have some market power.– Market Power – The ability to alter the market

price of a good or service.

• A monopolistically competitive firm confronts a downward-sloping demand curve.

Independent Production Decisions

• A monopolist is independent- doesn’t have to look over his shoulder for retaliatory competitor move.

• Monopolistic competitor has distinctive behavior which involves product differentiation.

Product or Brand Loyalty• By differentiating their products,

monopolistic competitors establish brand loyalty which gives them greater control over pricing.

• Translated as a “Monopoly” on their own brand… (Give me some examples)

Brand LoyaltyWill compete with other firms but offer

substitutesmakes the demand curve facing the firm

less price-elastic.implies that consumers shun substitute

goods even when they are cheaper.Example: the price differences between

computers which are essentially the same.

Example: Differentiation at the Graveyard—High-Definition RIP• For centuries, graveyard operators have explored the limits of product

differentiation.

• In most graveyards, tombstones come in all manners of shapes, sizes and colors.

• In the latest twist on tombstone differentiation, one producer offers tombstones that come equipped with solar-powered speaker systems and flat-panel screens.

• What does a seller of grave markers gain from product differentiation?

Non-price competition

Advertising.

http://www.youtube.com/watch?v=xffOCZYX6F8

http://www.youtube.com/watch?v=xffOCZYX6F8http://www.youtube.com/watch?v=xffOCZYX6F8

• What do you think?

– Would a perfect competitor have any incentive to advertise?

– Why would a monopolistically competitive firm advertise?

– Can advertising lead to efficiency?

• Sales promotion and advertising

– Can increase demand for a firm

– Can differentiate a firm’s product

– Can result in increased profits

Monopolistic Competition• Question

– How much advertising should be undertaken?

• Answer

• It should be carried to the point at which the additional revenue from one more dollar of advertising just equals that one dollar of additional cost.

Then there is the Super Bowl – hedging their bets on the quality of their advertising and product demand

Short Run Price and Output– Production Decision - The production decision is the

selection of the short-run rate of output.

As always, the profit-maximizing rate of output is achieved by producing the quantity where MR = MC.

New firms enter when there is an economic profit and leave when there is not.

In the long run, there are no pure economic profits in monopolistic competition.

Which other market model has long run zero or normal profit?

• When firms enter a monopolistically competitive industry:

– The market supply curve shifts to the right.

– The demand curves facing individual firms shift to the left.

PR

ICE

(p

er u

nit)

QUANTITY (units per time period)

New entryMarket

demand

Later market supply

Initial market supply

Effect of entry on the industry

PR

ICE

(p

er u

nit)

QUANTITY (units per time period)

Initial demand facing firm

Reduced market share

Later demand facing film

Effect of entry on the mono-polistically competitive firm

Equilibrium in Monopolistic Competition

QUANTITY(units per period)Later MRqg

pg

0

GATC

MC

PR

ICE

OR

CO

ST

(dol

lars

per

uni

t)

Later demand

Initial demand

The long run

PR

ICE

OR

CO

ST

(dol

lars

per

uni

t)

MRqa

0

paF

MCATC

QUANTITY (units per period)

DemandK

The short run

• Because of the industry-wide excess capacity in monopolistic competition, each firm is producing at a rate of output that is less than its minimum-ATC output rate.

QUANTITY(units per period)Later MRqg

pg

0

GATC

MC

PR

ICE

OR

CO

ST

(dol

lars

per

uni

t)

Later demand

Initial demand

The long runNote: the lessEfficient productionOf Mono Comp fromPerfect Comp

Figure 26-2 Comparison of the Perfect Competitor with the Monopolistic Competitor

• Thus, the same level of industry output could be produced at lower cost with fewer firms.

• Monopolistic competition results in both production inefficiency (above-minimum average cost) and allocative inefficiency (wrong mix of output).

Remember! Difference between two terms!

D

MR

P1

ATCP

rice

an

d C

ost

s

Q1

Short-RunEconomic

Profits

Expect New Competitors

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A1

MC

D

MR

P1

ATCP

rice

an

d C

ost

s

Q1

Expect New Competitors

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A1

New competition drives down theprice level – leading to economic

losses in the short run.

MC

Short-RunEconomic

Profits

D

MR

MC

P2

ATCP

rice

an

d C

ost

s

Q2

Short-RunEconomic

Losses

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A2

D

MR

MC

P3 = A3

ATCP

rice

an

d C

ost

s

Q3

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

Long-Run EquilibriumNormalProfitOnly

Advertising Wars• In truly (perfectly) competitive

industries, firms compete on the basis of price.

• Imperfectly competitive firms engage in nonprice competition with the most prominent form of nonprice competition being advertising.

• Advertising may be more responsible for brand loyalty than the taste of the product.

Characteristics • Differentiated Products

– Product Attributes– Service– Location– Brand Names and Packaging– Some Control Over Price– Easy Entry and Exit– Advertising

Characteristics continued

• Relatively Large Number of Sellers– Small Market Shares– No Collusion– Independent Action

D

MR

P1

ATCP

rice

an

d C

ost

s

Q1

Short-RunEconomic

Profits

Expect New Competitors

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A1

MC

D

MR

P1

ATCP

rice

an

d C

ost

s

Q1

Expect New Competitors

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A1

New competition drives down theprice level – leading to economic

losses in the short run.

MC

Short-RunEconomic

Profits

D

MR

MC

P2

ATCP

rice

an

d C

ost

s

Q2

Short-RunEconomic

Losses

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A2

D

MR

MC

P3 = A3

ATCP

rice

an

d C

ost

s

Q3

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

Long-Run EquilibriumNormalProfitOnly

Graph A shows short-run profits when there are few firms in the market

Graph B shows short-run losses as other companies see the success and join the market causing profits to drop

Graph C shows long-run equilibrium as the weaker firms leave the industry

Never underestimate power of an ad!

• http://www.youtube.com/watch?v=341rybZ42vA