Principles of Microeconomics Lecture 13 Monopolistic Competition Monopolistic

Principles of Microeconomics: Lecture 13 Monopolistic Competition

Monopolistic Competition

Introduction Two extremes market structures: Perfect competition: many firms, identical products Monopoly: one firm, unique product In between these extremes, lies imperfect competition: Oligopoly: only a few sellers offer similar or identical products. Monopolistic competition: many firms sell similar but not identical products (i. e. product differentiation).

Monopolistic Competition Characteristics: Many sellers Product differentiation Free entry and exit Examples: Apartments Books Bottled water Clothing Fast Food

A Monopolistically Competitive Firm Earning Profits in the Short Run • • • This firm faces a downwardsloping D curve. At each Q, MR < P (The MR cure is below the D-curve). Price The D-curve is flatter than for a monopoly. profit MC ATC P To maximize profit, firm produces ATC Q where MR = MC and chooses P using the D curve. • For this firm, P > ATC at the output where MR = MC. • Therefore, it is making profits in the short-term. D MR Q Quantity

A Monopolistically Competitive Firm with Losses in the Short Run • • For this firm, P < ATC at the output where MR = MC. The best this firm can do is to minimize its losses. Price MC losses ATC P D MR Q Quantity

Monopolistic Competition and Monopoly • Short run: Under monopolistic competition, firm behavior is very similar to monopoly. • Long run: In monopolistic competition, entry and exit drive economic profit to zero. If profits are made in the short run: New firms enter market, taking some demand away from existing firms, prices and profits fall. If losses are made in the short run: Some firms exit the market, remaining firms enjoy higher demand prices.

A Monopolistic Competitor in the Long Run • • Entry and exit occurs until P = ATC and profit = zero. Notice that the firm charges a markup of price over marginal cost and does not produce at minimum ATC. Price MC ATC P = ATC markup D MC MR Q Quantity

Why Monopolistic Competition is Less Efficient than Perfect Competition 1. Excess capacity The monopolistic competitor operates on the downward-sloping part of its ATC curve, produces less than the cost-minimizing output. Under perfect competition, firms produce the quantity that minimizes ATC. 2. Markup over marginal cost Under monopolistic competition, P > MC. Under perfect competition, P = MC.

Monopolistic Competition and Welfare • Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. • Because P > MC, the market quantity is below the socially efficient quantity. • The inefficiencies of monopolistic competition are subtle and hard to measure. No easy way for policymakers to improve the market outcome.

Advertising & Branding

Advertising • In monopolistically competitive markets, product differentiation & mark-up pricing lead naturally to the use of advertising. • In general, the more differentiated the products, the more advertising firms use. • Economists disagree on the social value of advertising.

Advertising Arguments For • Advertising provides useful information to buyers. • Informed buyers can more easily find and exploit price differences. • Advertising promotes competition and reduces market power. Arguments Against • Society may be wasting resources it devotes to advertising. • Firms may advertise to manipulate people’s tastes. • Advertising impedes competition – it creates the perception that products are more differentiated than they really are, allowing for mark ups.

Advertising as a Signal of Quality • A company’s willingness to spend huge amounts on advertising may signal the quality of products to consumers, regardless of the content of ads. Ads may convince buyers to try a product once, but the products must be of high quality for people to become repeat buyers. The most expensive ads are not worth while unless they lead to repeat buys. When consumers see expensive ads, they think the product must be good if the company is willing to spend so much on advertising.

Branding • In many products, brand names coexist with generic ones. • Firms with brand names usually spend more on advertising & charge higher prices. • As with advertising, there is a disagreement about the economics of brand names…

Branding Arguments For Arguments Against • Brand names provide information about quality to consumers. • Brand names cause consumers to perceive differences that do not really exist. • Companies with brand names have incentive to maintain quality to protect their reputation and their brand name. • Consumers’ willingness to pay more for brand names is irrational, fostered by advertising. • Eliminating govt. protection of trademarks would reduce influence of brand names & result in lower prices.

Review of Market Structures

Comparison of Market Structures Perfect Competition Monopolistic Competition Monopoly Number of Sellers Many One Free entry/exit Yes No Long-run economic profits Zero Profit The products firm sell Identical Differentiated One unique product Firms have market No (Price-takers) power Yes (Price-maker) Firm’s D-curve Downward sloping Horizontal

Welfare Effects of Market Structures • Perfect Competition is the most efficient market structure because it maximizes total welfare or surplus: ØP= MR=MC ØThe value to buyers of the marginal unit (P) will be equal to the cost to sellers of producing the marginal unit (MC). • In both monopoly and monopolistic competition, there is a welfare loss (deadweight loss): ØP > MR = MC The value to buyers of the marginal unit (P) will be greater than the cost to sellers of producing the marginal unit (MC). As a result, the Q is too low. Total surplus could be increased by increasing Q.

Determining Profits or Losses • In all three markets, four main curves used in the analysis: 1. 2. 3. 4. • MC curve (upward-sloping); ATC curve (u-shape); MR curve; Firm’s D-curve. To determine a firm’s profit or losses: 1. First, identify the profit maximizing quantity (Q) where MR=MC 2. Next, identify the price (P) set by the firm given Q 3. Finally, compare the vertical distance between P and where the Q hits the ATC curve ØIf P>ATC PROFITS ØIf P<ATC LOSSES

Perfect Competition A competitive firm Profit Max: MR= MC Perfect Comp. : P=MR (Shown by horizontal Dcurve being the same as the MR curve) Costs, P MC P MR ATC profit ATC Total profit = height * width =Profit per unit * No. of units =(P-ATC) *Q 50 Q 21

Monopoly Profit Max: MR= MC A Monopoly Costs and Revenue MC P Monopolistic Comp: P>MR (Shown by horizontal Dcurve being higher than the MR curve) Total profit = height * width =Profit per unit * No. of units =(P-ATC) *Q ATC D MR Q Quantity

Monopolistic Competition A Monopolistically competitive Firm Profit Max: MR= MC Monopolistic Comp: P>MR (Shown by horizontal Dcurve being higher than the MR curve) Price profit MC ATC P ATC D MR Total profit = height * width =Profit per unit * No. of units =(P-ATC) *Q Q Quantity

Reading • Textbook: Mankiw, N. (2009). Principles of economics (5 th ed. ). Mason, OH: Thomson South-Western Chapter 16