Chapter 16 Monopolistic Competition and Product Differentiation

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1 Goldwasser AP Microeconomics Chapter 16 Monopolistic Competition and Product Differentiation BEFORE YOU READ THE CHAPTER Summary This chapter develops the model of monopolistic competition. It also discusses product differentiation and why oligopolistic and monopolistically competitive firms engage in product differentiation. The chapter discusses the determination of prices and profits in monopolistic competition in both the short run and the long run. The chapter explores why monopolistic competition generates diversity of products and the cost of this diversity. The chapter also considers the costs and benefits from advertising and the creation of brand names. Chapter Objectives Objective #1. A monopolistically competitive industry is composed of many competing firms selling differentiated products with free entry and exit of firms in the long run. The three essential characteristics of monopolistic competition are a large number of producers, differentiated products, and free entry and exit of firms in the long run. Analysis of this market structure reveals that in some ways it resembles perfect competition and in other ways it resembles monopoly. Objective #2. Because monopolistically competitive firms sell differentiated products, each firm has some degree of market power and therefore faces a downward-sloping demand curve for its product. In fact, product differentiation is the only way monopolistically competitive firms acquire market power. This implies that these firms, like a monopoly, have some power to set the price they charge for their product. However, these firms also face competition, and due to free entry and exit in the long run will find that their long-run economic profit is equal to zero. There is no tendency toward collusion in a monopolistically competitive market since all firms recognize that new firms can enter the industry in the long run. Objective #3. Product differentiation takes three general forms: differentiation by style or type, differentiation by location, and differentiation by quality. Differentiation by style or type creates products that are imperfect substitutes for one another. Differentiation by location offers essentially identical products that are differentiated by their proximity and convenience to the buyer. Differentiation by quality provides a range of products that are of different quality levels to buyers. No matter what type of product differentiation we consider, the monopolistically competitive market structure is characterized by competition among sellers and a more diverse array of products.

2 Objective #4. In the short run, a monopolistically competitive firm produces the level of output where marginal revenue equals marginal cost (MR = MC) and then prices this output by going up to its demand curve. The monopolistically competitive firm's MR curve lies beneath its demand curve (you find it exactly the same way you found the MR curve for the monopoly). This firm will earn positive economic profits if price is greater than average total cost, and negative economic profits if price is less than average total cost. The monopolistically competitive firm acts exactly like a monopoly in the short run. Figure 16.1 illustrates a monopolistically competitive firm in the short run earning positive economic profits, while Figure 16.2 illustrates a monopolistically competitive firm in the short run earning negative economic profits.

3 Objective #5. In the long run, the monopolistically competitive firm earns zero economic profit due to the entry or exit of firms. If the monopolistically competitive firm earns positive economic profit in the short run, this acts as a signal for other firms to enter the industry. The entry of firms into the industry causes the demand curve for each existing firm to shift to the left so that at every price fewer units of their product are demanded. This process continues until there has been enough entry so that each firm's price equals average total cost. Figure 16.3 illustrates both the short-run and the longrun equilibrium for a monopolistically competitive firm with positive economic profits in the short run. Notice that this firm produces a smaller level of output and sells its good at a lower price in the long run than it did in the short run.

4 If the monopolistically competitive firm earns negative economic profit in the short run, this acts as a signal for some of the firms in the industry to exit in the long run. This exit of firms from the industry causes the demand curve for each remaining firm to shift to the right so that at every price more units of their product are demanded. This process continues until there has been enough exiting so that each remaining firm's price equals its average total cost. Figure 16.4 illustrates both the short-run and the long-run equilibrium for a monopolistically competitive firm with negative economic profits in the short run. Notice that this firm produces a higher level of output and sells this output at a higher price in the long run than it did in the short run. If the monopolistically competitive firm earns negative economic profit in the short run, this acts as a signal for some of the firms in the industry to exit in the long run. This exit of firms from the industry causes the demand curve for each remaining firm to shift to the right so that at every price more units of their product are demanded. This process continues until there has been enough exiting so that each remaining firm's price equals its average total cost. Figure 16.4 illustrates both the short-run and the long-run equilibrium for a monopolistically competitive firm with negative economic profits in the short run. Notice that this firm produces a higher level of output and sells this output at a higher price in the long run than it did in the short run. Objective #6. In the long run, each firm in a monopolistically competitive industry acts like a monopolist in setting marginal revenue equal to marginal cost and producing the quantity of output so as to maximize profits. However, in the long run the producers earn zero economic profits, unlike the long-run result for monopoly.

5 Objective #7. The long-run equilibrium in monopolistic competition also resembles the perfect competition result, since firms earn zero economic profit and their price equals average total cost. But there is a critical difference between longrun equilibrium in perfect competition and long-run equilibrium in a monopolistically competitive industry: in perfect competition, price is equal to the minimum of average total cost, while in monopolistic competition, price is equal to average total cost but not at the minimum-cost point of the average total cost (ATC) curve. The monopolistically competitive firm has excess capacity in the long run even though it earns zero economic profit; this excess capacity is another way of saying that the monopolistically competitive firm is not producing at minimum cost. This excess capacity of the monopolistically competitive firm arises from the cost of providing variety in the industry: the excess capacity is a sign of wasteful duplication that could be eliminated if there were fewer firms in the industry offering less-differentiated products. Yet consumers enjoy this diversity of products and it is valuable to them. Objective #8. In the long run, the perfectly competitive firm produces at a level where price equals marginal cost, while the monopolistically competitive firm produces at a level where price is greater than marginal cost. The monopolistically competitive firm in the long run is interested in selling more units of the good, since price is greater than marginal cost for the last unit produced. This helps us understand why monopolistically competitive firms advertise their product. Objective #9. Advertising is worthwhile in industries where firms have some degree of market power. Advertising may help to establish the quality of a firm's product. Advertising may also convey important information. The establishment of a brand name may be a way of signaling quality to a consumer. Key Terms Notes monopolistic competition a market structure in which there are many competing producers in an industry, each producer sells a differentiated product, and there is free entry and exit into and from the industry in the long run. zero-profit equilibrium an economic balance in which each firm makes zero profit at its profit-maximizing quantity. excess capacity when firms produce less than the output at which average total cost is minimized; characteristic of monopolistically competitive firms. brand name a name owned by a particular firm that distinguishes its products from those of other firms.

6 AFTER YOU READ THE CHAPTER Tips Tip #1. Monopolistic competition is an odd blend of elements from the monopoly model and from the perfect competition model. It is important that you understand these elements and how they work. Let's start with an analysis of the short-run situation. First, the monopolistically competitive firm faces a downward-sloping demand curve and, therefore, a MR curve that is beneath its demand curve. This is like monopoly. Second, the monopolistically competitive firm profit maximizes by producing the quantity where MR = MC This is like both perfect competition and monopoly. Third, the price the monopolistically competitive firm charges for its good is found by taking the profit-maximizing quantity and looking at the demand curve for the price associated with that quantity. This is exactly what a monopoly does. In the short run, the monopolistically competitive firm exactly mimics the behavior of a monopoly. So, just remember your work with monopoly and apply those same rules. In the short run, the monopolistically competitive firm can earn positive, negative, or zero economic profit. Tip #2. In the long run, the monopolistically competitive firm is subject to entry of new firms into the industry and the exit of existing firms from the industry. This is a characteristic that makes the monopolistically competitive industry resemble perfect competition. But there's an important distinction: even though economic profit equals zero in the long run for both market structures, the monopolistically competitive firm faces a downward-sloping demand curve, which means that price and marginal revenue are not the same for this firm. It implies that even when the monopolistically competitive firm earns zero economic profit in the long run, it charges a price that is greater than its marginal cost. This is different from the result found in perfect competition. Also, in perfect competition in the long run, price = MR = MC= minimum ATC. In monopolistic competition in the long run, MR = MC and price = ATC, but price is not equal to marginal cost and price is not equal to the minimum average total cost. Review these two tips thoroughly until you have mastered them and understand the implications of the points made in each tip.