Monopolistic Competition

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1 CHAPTER 13A After studying this chapter you will be able to Monopolistic Define and identify monopolistic competition Explain how output and price are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry PC War Games Globalization brings enormous diversity in products and thousands of firms seek to make their own product special and different from the rest of the pack. Dell, Hewlett-Packard, Lenovo, Acer, and Toshiba accounted for one half of the global market of $60 million PCs in Firms in these markets are neither price takers like those in perfect competition, nor are they protected from competition by barriers to entry like a monopoly. How do such firms choose the quantity to produce and price? What Is Monopolistic? Monopolistic competition is a market with the following characteristics: A large number of firms. Each firm produces a differentiated product. Firms compete on product quality, price, and marketing. Firms are free to enter and exit the industry. What Is Monopolistic? What Is Monopolistic? Large Number of Firms The presence of a large number of firms in the market implies: Each firm has only a small market share and therefore has limited market power to influence the price of its product. Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other, and no one firm s actions directly affect the actions of other firms. Collusion, or conspiring to fix prices, is impossible. Product Differentiation Firms in monopolistic competition practice product differentiation, which means that each firm makes a product that is slightly different from the products of competing firms. 1

2 What Is Monopolistic? What Is Monopolistic? Competing on Quality, Price, and Marketing Product differentiation enables firms to compete in three areas: quality, price, and marketing. Quality includes design, reliability, and service. Because firms produce differentiated products, each firm has a downward-sloping demand curve for its own product. But there is a tradeoff between price and quality. Differentiated products must be marketed using advertising and packaging. Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. Examples of Monopolistic Figure 13.1 on the next slide shows market share of the largest four firms and the HHI for each of ten industries that operate in monopolistic competition. What Is Monopolistic? Figure 13.1 shows examples. The 4 largest firms. Next 4 largest firms. Next 12 largest firms. The numbers are the HHI. The Firm s Short-Run Output and Price Decision A firm that has decided the quality of its product and its marketing program produces the profit-maximizing quantity at which its marginal revenue equals its marginal cost (MR = MC). Price is set at the highest price the firm can charge for the profit-maximizing quantity. The price is determined from the demand curve for the firm s product. Figure 13.2 shows a short-run equilibrium for a firm in monopolistic competition. It operates much like a single-price monopoly. 2

3 The firm produces the quantity at which marginal revenue equals marginal cost and sells that quantity for the highest possible price. It makes an economic profit (as in this example) when P > ATC. Profit Maximizing Might be Loss Minimizing A firm might incur an economic loss in the short run. Here is an example. In this case, P < ATC. Long Run: Zero Economic Profit In the long run, economic profit induces entry. And entry continues as long as firms in the industry make an economic profit as long as (P > ATC). In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC. As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward. The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity. Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit. 3

4 Figure 13.4 shows a firm in monopolistic competition in long-run equilibrium. If firms incur an economic loss, firms exit to achieve the long-run equilibrium. Monopolistic and Perfect Two key differences between monopolistic competition and perfect competition are: Excess capacity Markup A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. A firm s markup is the amount by which its price exceeds its marginal cost. Excess Capacity Firms in monopolistic competition operate with excess capacity in longrun equilibrium. The downward-sloping demand curve for their products drives this result. Markup Firms in monopolistic competition operate with positive mark up. Again, the downwardsloping demand curve for their products drives this result. 4

5 In contrast, firms in perfect competition have no excess capacity and no markup. The perfectly elastic demand curve for their products drives this result. Is Monopolistic Efficient Because in monopolistic competition P > MC, marginal benefit exceeds marginal cost. So monopolistic competition seems to be inefficient. But the markup of price above marginal cost arises from product differentiation. People value variety but variety is costly. Monopolistic competition brings the profitable and possibly efficient amount of variety to market. Innovation and Product Development We ve looked at a firm s profit-maximizing output decision in the short run and the long run of a given product and with given marketing effort. To keep making an economic profit, a firm in monopolistic competition must be in a state of continuous product development. New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation. Profit-Maximizing Product Innovation Innovation is costly, but it increases total revenue. Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation. 5

6 Efficiency and Product Innovation Marginal social benefit of an innovation is the increase in the price that people are willing to pay for the innovation. Marginal social cost is the amount that the firm must pay to make the innovation. Profit is maximized when marginal revenue equals marginal cost. In monopolistic competition, price exceeds marginal revenue, so the amount of innovation is probably less than efficient. Advertising Firms in monopolistic competition incur heavy advertising expenditures. Figure 13.6 shows estimates of the percentage of sale price for different monopolistic competition markets. Cleaning supplies and toys top the list at almost 15 percent. Manufacturer (Asia) Materials Cost of labor Cost of capital Profit Shipping Import duties Nike (Beaverton, Oregon) Sales, distribution, and administration Advertising Research and development Nike's profit Retailer (your town) Sales clerks wages Shop rent Retailers other costs Retailer's profit Totals ATC $70.00 AFC $6.50 AVC $63.50 Selling Costs and Total Costs Selling costs, like advertising expenditures, fancy retail buildings, etc. are fixed costs. Average fixed costs decrease as production increases, so selling costs increase average total costs at any given level of output but do not affect the marginal cost of production. Selling efforts such as advertising are successful if they increase the demand for the firm s product. Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced. Here, with no advertising, the firm produces 25 units of output at an average total cost of $60. 6

7 The advertising expenditure shifts the average total cost curve upward. With advertising, the firm produces 100 units of output at an average total cost of $40. The firm operates at a higher output and lower average total cost than it would without advertising. Selling Costs and Demand In Figure 13.8(a), with no advertising, demand is not very elastic and the markup is large. In Figure 13.8(b), advertising makes demand more elastic, increases the quantity and lowers the price and markup. Using Advertising to Signal Quality Why do Coke and Pepsi spend millions of dollars a month advertising products that everyone knows? One answer is that these firms use advertising to signal the high quality of their products. A signal is an action taken by an informed person or firm to send a message to uninformed persons. 7

8 For example, Coke is a high quality cola and Oke is a low quality cola. If Coke spends millions on advertising, people think Coke must be good. If it is truly good, when they try it, they will like it and keep buying it. If Oke spends millions on advertising, people think Oke must be good. If it is truly bad, when they try it, they will hate it and stop buying it. So if Oke knows its product is bad, it will not bother to waste millions on advertising it. And if Coke knows its product is good, it will spend millions on advertising it. Consumers will read the signals and get the correct message. None of the ads need mention the product. They just need to be flashy and expensive. THE END 8

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