12 Monopolistic Competition and Advertising Previously Price discrimination

12 Monopolistic Competition and Advertising

Previously • Price discrimination – Occurs when a firm charges buyers different prices for the same good or service – Increases firm profits and total welfare • General rule for price discrimination: – Charge higher (lower) prices to consumers with relatively inelastic (elastic) demands.

Practice What You Know— 1 • Which of the following industries fits most closely with the model of monopolistic competition? A. automobile production B. farming C. diamond mining D. fast-food restaurants

Practice What You Know— 2 • Which of the following is a monopolistic competitor? A. a local farm that grows Granny Smith apples B. your local electric company C. a big and tall clothing store D. General Motors

Practice What You Know— 3 • Which of the following is true about monopolistic competition? A. It results in higher prices than monopoly. B. It results in higher prices than perfect competition. C. It results in lower quantity than monopoly. D. It is more economically efficient than perfect competition.

Big Questions 1. What is monopolistic competition? 2. What are the differences among monopolistic competition, competitive markets, and monopoly? 3. Why is advertising prevalent in monopolistic competition?

What Is Monopolistic Competition? • Market structure: – Many different firms – Products are differentiated – Free entry and exit • Product differentiation – Process that firms use to make a product more attractive by contrasting its unique qualities with competing products

Comparing Market Structures Perfectly Competitive Markets Monopolistic Competition Monopoly Many sellers One seller Similar products Differentiated products A unique product without close substitutes Free entry and exit Low barriers to entry and exit Barriers to entry and exit

Product Differentiation— 1 • What are some ways firms differentiate their products? – Style or type – Location – Quality

Product Differentiation— 2 • Important point to remember: De gustibus non est disputandum or “In matters of taste, there can be no disputes”

Economics in Seinfeld, “The Café” • Babu’s restaurant has few customers, so Jerry convinces Babu to serve Pakistani food.

Economics in American Gangster • “Blue Magic”—a brand that signals quality

Differences among the Three Market Types • Perfect competition: – Low prices – Efficient level of output • Monopoly: – High prices – Inefficient level of output • Monopolistic competition: –?

Monopolistic Competition in the Short Run

Monopolistic Competition in the Long Run— 1 • In the short run, a monopolistically competitive firm may earn profits or losses. – What will occur in the long run? – Why?

Monopolistic Competition in the Long Run— 2

Monopolistic Competition and Competitive Markets— 1 • Price, Marginal Cost and Long-Run ATC Cost – Perfect competition: P = MC – Monopolistic competition: P > MC – Markup: P - MC – Perfect competition: P = min ATC – Monopolistic competition: P > min ATC

LR Equilibrium in Two Market Structures— 1

Monopolistic Competition and Competitive Markets— 2 • Scale and output – Perfect competition: • In the long run, a firm produces at minimum efficient scale. – Monopolistic competition: • In the long run, a firm produces with excess capacity.

LR Equilibrium in Two Market Structures— 2

On Scale and Output • Why not produce more? – The firm would have to lower the price. – It is more profitable to produce at excess capacity. • Compare to perfect competition – Perfectly competitive firms operate at capacity at the minimum of ATC. – Overall output is higher in perfect competition.

Inefficiency and Social Welfare— 1 • Is monopolistic competition efficient? – No – Two sources of inefficiency: 1. ATC is higher compared to perfect competition 2. Markup: P > MC

Inefficiency and Social Welfare— 2 • Should the government intervene? – Firms are not able to earn long-run profits since there are no barriers. – Regulation may put many firms out of business. – Less firms may mean more inconvenience and fewer choices for consumers. – Inefficiency is not large enough to warrant government intervention

Varying Degrees of Product Differentiation— 1 • How does the loss in efficiency relate to the degree of product differentiation? “High” Degree “Low” Degree

Varying Degrees of Product Differentiation— 2 • A highly differentiated product means – Higher prices and markups – Larger excess capacity • A less-differentiated product means – Lower prices and markups – Less excess capacity

Differentiation, Excess Capacity, and Efficiency

Is Inefficiency So Bad? Which Would You Prefer? — 1 • Situation A: – Pizza is produced in slightly higher quantities with slightly lower prices than it currently is. – However, all pizza is the same brand (all pizza restaurants are Pizza Hut, for example).

Is Inefficiency So Bad? Which Would You Prefer? — 2 • Situation B: – Pizza is produced as it currently is today: slightly lower quantities with slightly higher prices (compared to under perfect competition). However, you have more variety and choice, and there are many different types and styles of pizza being made at different restaurants.

Economics in South Park, “Gnomes” • Harbucks moves into town, creating dire effects on the local coffee shop.

Practice What You Know— 4 • What is true about the long-run equilibrium for firms in a monopolistically competitive industry? A. MR < MC, P < min(ATC) B. P = MR = MC = min(ATC) C. P = ATC, P > MC, P > min(ATC) D. P > ATC, P = MC

Practice What You Know— 5 • Which of the following is true about product differentiation? A. More differentiation means products are more substitutable for each other. B. More differentiation leads to greater differences in price. C. More differentiation leads to converging prices. D. Differentiation lowers firm profits.

Economics in E. T. the Extraterrestrial • Reese’s Pieces wins big with product placement.

Economics in “Free Hugs Prank: $2 Deluxe Hugs” • Is a $2 hug better than a free hug?

Why Is Advertising Prevalent in Monopolistic Competition? — 1 • Why do firms advertise? – Change the demand for the product

Advertising and Demand

Why Is Advertising Prevalent in Monopolistic Competition? — 2 • Why do firms advertise? – Increase demand for the product – Provide information to consumers – Form of non-price competition – Might signal quality

Advertising in Different Markets— 1 • In which market(s) do we see more or less advertising? • Perfect competition – Firms that advertise will have higher costs than rivals, without any gains – Advertising at the industry level

Advertising in Different Markets— 2 • Monopolistic competition – Advertising can increase demand for single firm’s product. – Gains from advertising go to the firm. – Want some pizza?

Advertising in Different Markets— 3 • Monopoly – Advertising less likely since the product has no close substitutes and consumer choice is limited – May advertise simply to inform consumer about the product and stimulate demand

Negative Effects of Advertising: Advertising and Costs • The paradox of advertising – Suppose Domino’s advertises. – All else equal, its sales will increase, and it will be able to recover its costs. – But, Papa John’s will respond with its own advertising campaign. – Net result: sales remain the same, but both firms have higher costs. – Negative business stealing externality

Advertising Increases Cost

Negative Effects of Advertising • Inspires brand loyalty – More inelastic demand, which raises prices to consumers – Want to buy some pearls? $43 $300

Economics in Mad Men, “Smoke Gets in Your Eyes” • “Everybody else’s tobacco is poisonous. Lucky Strike’s is toasted. ”

Negative Effects: Truth in Advertising • Advertising: Persuasive or informative? – Both, but advertising can be manipulative. – Firms may have an incentive to “lie. ” • FTC regulates advertising – Enforces truth-in-advertising laws – Food, drugs, supplements, alcohol, and tobacco

Conclusion • Monopolistic competition – Exists when many competing firms produce differentiated products – Has features of both perfect competition and monopoly – Is closer to perfect competition than monopoly in terms of prices, output, and efficiency – Is prevalent throughout our economy