MONOPOLISTIC COMPETITION Objectives After studying this chapter you

MONOPOLISTIC COMPETITION

Objectives After studying this chapter, you will able to § 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 Each PC maker tells us that they have the best product at the best price. Just two big chip makers produce almost all the processor and memory chips in our PCs. 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?

Monopolistic Competition 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.

Monopolistic Competition 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.

Monopolistic Competition 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.

Monopolistic Competition 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.

Monopolistic Competition Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run.

Output and Price in Monopolistic Competition Short-Run Economic Profit 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 determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profit-maximizing quantity.

Output and Price in Monopolistic Competition Figure 13. 2(a) shows a short-run equilibrium for a firm in monopolistic competition. It operates much like a single-price monopolist.

Output and Price in Monopolistic Competition The firm produces the quantity at which price equals marginal cost and sells that quantity for the highest possible price. It earns an economic profit (as in this example) when P > ATC.

Output and Price in Monopolistic Competition Long Run: Zero Economic Profit In the long run, economic profit induces entry. And entry continues as long as firms in the industry earn 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.

Output and Price in Monopolistic Competition 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.

Output and Price in Monopolistic Competition This figure shows a firm in monopolistic competition moving from short-run equilibrium to long-run equilibrium. If firms incur an economic loss, firms exit to restore the long-run equilibrium just described.

Output and Price in Monopolistic Competition and Efficiency Firms in monopolistic competition are inefficient and operate with excess capacity. Figure 13. 3 on the next slide illustrates these propositions.

Output and Price in Monopolistic Competition Because they productdifferentiate and face a downward-sloping demand curve for their products, firms in monopolistic competition receive a marginal revenue that is less than price for all levels of output.

Output and Price in Monopolistic Competition Firms maximize profit by setting marginal revenue equal to marginal cost, so with marginal revenue less than price, marginal cost is also less than price.

Output and Price in Monopolistic Competition Because price equals the marginal benefit, marginal cost is less than marginal benefit. Underproduction in monopolistic competition creates deadweight loss.

Output and Price in Monopolistic Competition A firm’s capacity output is the output at which average total cost is at its minimum. At the long-run profit maximizing output, price equals average total cost. But recall that MR < P, which means that MC < ATC.

Output and Price in Monopolistic Competition If MC < ATC, then the ATC curve is falling. With output in the range of falling ATC, output is less than capacity output. Goods are not produced at the minimum unit cost of production in the long run.

Product Development and Marketing 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 earning 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.

Product Development and Marketing Innovation is costly, but it increases total revenue. Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation. Production development may benefit the consumer by providing an improved product, or it may only create the appearance of a change in product quality. Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which is the amount the consumer is willing to pay for it.

Product Development and Marketing A firm’s marketing program uses advertising and packaging as the two principal methods to market its differentiated products to consumers. Firms in monopolistic competition incur heavy marketing and advertising expenditures to enhance the perception of quality differences between their product and rival products. These costs make up a large portion of the price for the product.

Product Development and Marketing Figure 13. 4 shows estimates of the percentage of sale price for different monopolistic competition markets. Cleaning supplies and toys top the list at almost 15 percent.

Product Development and Marketing 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.

Product Development and Marketing 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 $170.

Product Development and Marketing With advertising, the firm produces 130 units of output at an average total cost of $160. The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.

Product Development and Marketing But advertising can increase a firm’s demand profits in the short run only. Economic profit leads to entry, which decreases the demand for each firm’s product in the long run. To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are efficient.