THIRD EDITION. ECONOMICS and. MICROECONOMICS Paul Krugman Robin Wells. Chapter 15. Monopolistic Competition and Product Differentiation

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1 THIRD EDITION ECONOMICS and MICROECONOMICS Paul Krugman Robin Wells Chapter 15 Monopolistic Competition and Product Differentiation

2 WHAT YOU WILL LEARN IN THIS CHAPTER The meaning of monopolistic competition Why oligopolists and monopolistically competitive firms differentiate their products How prices and profits are determined in monopolistic competition in the short run and the long run Why monopolistic competition poses a trade-off between lower prices and greater product diversity The economic significance of advertising and brand names

3 The Meaning of Monopolistic Competition Monopolistic competition is a market structure in which there are many competing producers in an industry each producer sells a differentiated product there is free entry into and exit from the industry in the long run

4 Product Differentiation Product differentiation plays an even more crucial role in monopolistically competitive industries. Why? Tacit collusion is virtually impossible when there are many producers. Hence, product differentiation is the only way monopolistically competitive firms can acquire some market power.

5 Product Differentiation How do firms in the same industry such as fast-food vendors, gas stations, or chocolate companies differentiate their products? Is the difference mainly in the minds of consumers or in the products themselves?

6 Product Differentiation There are three important forms of product differentiation: 1) Differentiation by style or type sedans vs. SUVs 2) Differentiation by location dry cleaner near home vs. cheaper dry cleaner far away 3) Differentiation by quality ordinary chocolate ($) vs. gourmet chocolate ($$$)

7 Product Differentiation Whatever form it takes, however, there are two important features of industries with differentiated products: Competition among sellers: Producers compete for the same market, so entry by more producers reduces the quantity each existing producer sells at any given price. Value in diversity: In addition, consumers gain from the increased diversity of products.

8 ECONOMICS IN ACTION Any Color, So Long as It s Black Ford s strategy was to offer just one style of car, which maximized his economies of scale but made no concessions to differences in taste the Model T. Alfred P. Sloan of GM challenged this strategy by offering a range of car types, differentiated by quality and price, including Chevrolet, Cadillac, and Buick. By the 1930s the verdict was clear: Customers preferred a range of styles!

9 Understanding Monopolistic Competition As the term monopolistic competition suggests, this market structure combines some features typical of monopoly with others typical of perfect competition: Because each firm is offering a distinct product, it is in a way like a monopolist: it faces a downward-sloping demand curve and has some market power the ability within limits to determine the price of its product. However, unlike a pure monopolist, a monopolistically competitive firm does face competition: the amount of product it can sell depends on the prices and products offered by other firms in the industry.

10 The MC Firm in the Short Run The following figure shows two possible situations that a typical firm in a monopolistically competitive industry might face in the short run. In each case, the firm looks like any monopolist: it faces a downward-sloping demand curve, which implies a downward-sloping marginal revenue curve. We assume that every firm has an upward-sloping marginal cost curve, but that it also faces some fixed costs, so that its average total cost curve is U-shaped.

11 The MC Firm in the Short Run Price, cost, marginal revenue (a) A Profitable Firm MC Price, cost, marginal revenue (b) An Unprofitable Firm MC A T C A T C P P ATC P Profit ATC U P U Loss D P D U MR P MR U Q P Quantity Q U Quantity Profit-maximizing quantity Loss-minimizing quantity

12 Monopolistic Competition in the Long Run If the typical firm earns positive profits, new firms will enter the industry in the long run, shifting each existing firm s demand curve to the left. If the typical firm incurs losses, some existing firms will exit the industry in the long run, shifting the demand curve of each remaining firm to the right. In the long run, equilibrium of a monopolistically competitive industry, the zero-profit-equilibrium, firms just break even. The typical firm s demand curve is just tangent to its average total cost curve at its profit-maximizing output.

13 Entry and Exit Shift Existing Firm s Demand Curve and Marginal Revenue Curve Price, marginal revenue (a) Effects of Entry Price, marginal revenue (b) Effects of Exit Entry shifts the existing firm s demand curve and its marginal revenue curve leftward. Exit shifts the existing firm s demand curve and its marginal revenue curve rightward. D D MR MR MR MR D 2 D Quantity Quantity

14 FOR INQUIRING MINDS HITS AND FLOPS On the face of it, the movie business seems to meet the criteria for monopolistic competition. Movies compete for the same consumers; each movie is different from the others; new companies can and do enter the business. But where s the zero-profit equilibrium? After all, some movies are enormously profitable.

15 FOR INQUIRING MINDS HITS AND FLOPS The key is to realize that for every successful blockbuster, there are several flops and that the movie studios don t know in advance which will be which. The difference between movie-making and the type of monopolistic competition we model in this chapter is that the fixed costs of making a movie are also sunk costs once they ve been incurred, they can t be recovered.

16 FOR INQUIRING MINDS HITS AND FLOPS Yet, there is still, in a way, a zero-profit equilibrium. If movies on average were highly profitable, more studios would enter the industry and more movies would be made. If movies on average lost money, fewer movies would be made. In fact, as you might expect, the movie industry on average earns just about enough to cover the cost of production that is, it earns roughly zero economic profit.

17 ECONOMICS IN ACTION THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION A home owner looking to sell hires an agent, who lists the house for sale and shows it to interested buyers. Correspondingly, prospective home buyers hire their own agent to arrange inspections of available houses. Traditionally, agents were paid by the seller: a commission equal to 6% of the sales price of the house, which the seller s agent and the buyer s agent would split equally.

18 ECONOMICS IN ACTION THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION The real estate brokerage industry fits the model of monopolistic competition quite well: in any given local market, there are many real estate agents, all competing with one another, but the agents are differentiated by location and personality, as well as by the type of home they sell (some focus on condominiums, others on very expensive homes, and so on).

19 ECONOMICS IN ACTION THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION And the industry has free entry: it s relatively easy for someone to become a real estate agent (take a course and then pass a test to obtain a license). But for a long time there was one feature that didn t fit the model of monopolistic competition: the fixed 6% commission that had not changed over time and was unaffected by the ups and downs of the housing market.

20 ECONOMICS IN ACTION THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION But protecting the 6% commission was always an iffy endeavor because any action by the brokerage industry to fix the commission rate at a given percentage would run afoul of antitrust laws. And by the early to mid-2000s, as the housing boom intensified, discount brokers had appeared on the scene. But traditional agents refused to work with them.

21 ECONOMICS IN ACTION THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION So in 2005, the Justice Department sued the National Association of Realtors, the powerful trade group of agents. Oversight by regulators and the housing market bust which began in 2006 are hastening the demise of the non-negotiable 6% commission. With sellers forced to accept less for their houses than often anticipated, pressure has built for agents to accept less as well. By 2009, the average commission had fallen to 5.36%, and agents are now offering to list properties on broker databases for as little as a few hundred dollars.

22 The Long-Run Zero-Profit Equilibrium Price, cost, marginal revenue MC Point of tangency A T C P MC = A T C MC Z MR MC D MC Q MC Quantity

23 Monopolistic Competition versus Perfect Competition In the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit. Price exceeds marginal cost, so some mutually beneficial trades are unexploited. The following figure compares the long-run equilibrium of a typical firm in a perfectly competitive industry with that of a typical firm in a monopolistically competitive industry.

24 Comparing LR Equilibrium in PC and MC Price, cost, marginal revenue (a) Long-Run Equilibrium in Perfect Competition Price, cost, marginal revenue (b) Long-Run Equilibrium in Monopolistic Competition MC A T C MC A T C P PC = MC = PC A T C PC D = MR = P PC P = A T C MC MC MC MC MR D MC MC Q Q PC Quantity MC Quantity Minimum-cost output Minimum-cost output

25 Is Monopolistic Competition Inefficient? Firms in a monopolistically competitive industry have excess capacity: they produce less than the output at which average total cost is minimized. Price exceeds marginal cost, so some mutually beneficial trades are unexploited. The higher price consumers pay because of excess capacity is offset to some extent by the value they receive from greater diversity. Hence, it is not clear that this is actually a source of inefficiency.

26 Controversies About Product Differentiation No discussion of product differentiation is complete without spending at least a bit of time on the two related of advertising and brand names.

27 The Role of Advertising In industries with product differentiation, firms advertise to increase the demand for their products. Advertising is not a waste of resources when it gives consumers useful information about products. Advertising that simply touts a product is harder to explain. Either consumers are irrational, or expensive advertising communicates that the firm's products are of high quality.

28 Brand Names Some firms create brand names. A brand name is a name owned by a particular firm that distinguishes its products from those of other firms. As with advertising, the social value of brand names can be ambiguous. The names convey real information when they assure consumers of the quality of a product.

29 ECONOMICS IN ACTION Absolut Irrationality Vodka is aquavit, the most unsophisticated type of alcohol. It is bland, with no taste, no smell, and many brands are comparable. How then are products differentiated? Advertising!!! Consider Absolut vodka, whose magnetic advertising campaign has led to huge popularity for their brand. In Sweden (where Absolut is made), the locals prefer cheaper brands. This is because alcohol advertising is against the law in Sweden.

30 VIDEO TED TALK: Malcolm Gladwell on spaghetti sauce: auce.html

31 Summary 1. Monopolistic competition is a market structure in which there are many competing producers, each producing a differentiated product, and there is free entry and exit in the long run. Product differentiation takes three main forms: by style or type, by location, or by quality. 2. Short-run profits will attract entry of new firms in the long run. This reduces the quantity each existing producer sells at any given price and shifts its demand curve to the left. Short-run losses will induce exit by some firms in the long run. This shifts the demand curve of each remaining firm to the right.

32 Summary 3. In the long run, a monopolistically competitive industry is in zero-profit equilibrium: at its profit-maximizing quantity, the demand curve for each existing firm is tangent to its average total cost curve. There are zero profits in the industry and no entry or exit. 4. In long-run equilibrium, firms in a monopolistically competitive industry sell at a price greater than marginal cost. They also have excess capacity because they produce less than the minimum-cost output; as a result, they have higher costs than firms in a perfectly competitive industry.

33 Summary 5. A monopolistically competitive firm will always prefer to make an additional sale at the going price, so it will engage in advertising to increase demand for its product and enhance its market power. Advertising and brand names that provide useful information to consumers are economically valuable. But they are economically wasteful when their only purpose is to create market power. In reality, advertising and brand names are likely to be some of both: economically valuable and economically wasteful.

34 KEY TERMS Monopolistic competition Zero-profit equilibrium Excess capacity Brand name