Chapter 26 Monopolistic Competition - …wps.pearsoncustom.com/wps/media/objects/9875/... · 26-28 Copyright © 2011 Pearson Education, Inc. All rights reserved. Comparing Perfect

Copyright ©2011 by Pearson Education, Inc.All rights reserved.

Chapter 26

Monopolistic Competition

26-2Copyright © 2011 Pearson Education, Inc. All rights reserved.

Introduction

After spending an afternoon on the lots of auto dealers, you still can’t quite decide among the available vehicle models.

There is the MDX, MKX, RSX, RX, Q7, Q45, M3, M35, and two different LS models to choose from.

How do auto makers selling similarly named yet slightly different brands determine how many vehicles to produce and what prices to charge?

To find out the answer to this question, you must learn about the market structure in which today’s auto producers interact, known as monopolistic competition.


Learning Objectives

• Discuss the key characteristics of a monopolistically competitive industry

• Contrast the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms


Learning Objectives (cont'd)

• Explain why brand names and advertising are important features of monopolistically competitive industries

• Describe the fundamental properties of information products and evaluate how the prices of these products are determined under monopolistic competition


Chapter Outline

• Monopolistic Competition• Price and Output for the Monopolistic

Competitor• Comparing Perfect Competition with

Monopolistic Competition • Brand Names and Advertising• Information Products and Monopolistic

Competition


Did You Know That…

• Only one out of every three new soft drinks that sellers introduce ultimately remains in production more than a few years?

• Two-thirds of soft drinks that sellers introduce into the market ultimately are withdrawn from production.

• Product heterogeneity and advertising did not show up in our analysis of perfect competition. They play large roles, however, in industries that cannot be described as perfectly competitive but cannot be described as pure monopolies either.


Monopolistic Competition

• In the 1920s and 1930s, economists were aware of industries that did not fit under perfect competition or pure monopoly.

• Theoretical and empirical research was instituted to develop some sort of middle ground.


Monopolistic Competition (cont'd)

• Two separately developed models of monopolistic competition resulted.

• At Harvard, Edward Chamberlin published Theory of Monopolistic Competition in 1933.

• That same year, Joan Robinson of Cambridge published The Economics of Imperfect Competition.



• Monopolistic Competition

– A market situation in which a large number of firms produce similar but not identical products.

– Entry into the industry is relatively easy.



• Characteristics of monopolistic competition

1. Significant numbers of sellers in a highly competitive market

2. Differentiated products

3. Sales promotion and advertising

4. Easy entry of new firms in the long run



• Implications of the large number of firms

1. Small market share

2. Lack of collusion

3. Independence



• Product Differentiation

– The distinguishing of products by brand name, color, and other minor attributes.



• Product differentiation and price

– The firm has some control over the price it charges.

– Unlike a perfect competitor, it faces a downward sloping demand curve.

– Consider the abundance of brand names for many products.• The more successful the firm is at differentiation, the

more control it has over price.


Example: Differentiation at the Graveyard—High-Definition RIP

• For centuries, graveyard operators have explored the limits of product differentiation.

• In most graveyards, tombstones come in all manners of shapes, sizes and colors.

• In the latest twist on tombstone differentiation, one producer offers tombstones that come equipped with solar-powered speaker systems and flat-panel screens.

• What does a seller of grave markers gain from product differentiation?



• What do you think?

– Would a perfect competitor have any incentive to advertise?

– Why would a monopolistically competitive firm advertise?

– Can advertising lead to efficiency?



• Sales promotion and advertising

– Can increase demand for a firm

– Can differentiate a firm’s product

– Can result in increased profits



• Question– How much advertising should be undertaken?

• Answer– It should be carried to the point at which the

additional revenue from one more dollar of advertising just equals that one dollar of additional cost.


Example: Firms Sell with Smell

• A new approach to advertising is to sell with smell.• More and more companies have developed new

ways to advertise products on the basis of odor differentiation.

• These firms are using product odors to try to induce consumers to discover a preference for their fragrance-differentiated products.

• How will successful advertising affect the demand for a monopolistically competitive firm’s differentiated product?



• Ease of entry

– For any current monopolistic competitor, potential competition is always lurking in the background.

– The easier—that is, the less costly—entry is, the more a current competitor must worry about losing business.


Price and Output for the Monopolistic Competitor

• The individual firm’s demand and cost curves

– Demand curve slopes downward

– Profit maximized where MC intersects MR from below


Price and Output for the Monopolistic Competitor (cont'd)

• Short-run equilibrium

– In the short run, it is possible for a monopolistic competitor to make economic profits—profits over and above the normal rate of return, or beyond what is necessary to keep that firm in the industry.

– Losses in the short run are clearly also possible.


Price and Output for the Monopolistic Competitor (cont'd)

• The long run: zero economic profits

– The rate of return will tend toward normal.

– Economic profits will tend toward zero.• So many firms produce substitutes, any economic

profits will disappear with competition.• Reduced to zero either through entry of new firms

seeking to earn a higher rate or return, or by changes in product quality and advertising outlays by existing firms


Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (a)

• Price (P1) > ATC• Economic profit


Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (b)

• Price (P1) < ATC• Economic loss


Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (c)

• Price (P1) = ATC• Normal rate of return


Comparing Perfect Competition with Monopolistic Competition

• Question– If both a monopolistic and perfect competitor

make zero economic profit in the long run, how are they different?

• Answer– Demand curve for individual perfect competitor

is perfectly elastic.


Figure 26-2 Comparison of the Perfect Competitor with the Monopolistic Competitor


Comparing Perfect Competition with Monopolistic Competition (cont'd)

• In perfect competition, the long-run equilibrium occurs where average total cost is minimized (this does not occur in monopolistic competition).

• Some have argued that this is not necessarily a waste of resources—as the added cost arises from product differentiation.

• Chamberlin argued it is rational for consumers to have a taste for differentiation; consumers willingly accept the resultant increased production costs in return for more choice and variety of output.


Brand Names and Advertising

• Because “differentness” has value for consumers, monopolistically competitive firms regard their brand names as valuable private (intellectual) property.

– Firms use trademarks, words, symbols, and logos to distinguish their product brands from goods or services sold by other firms• A successful brand image contributes to a firm’s

profitability.


Brand Names and Advertising (cont'd)

• Brand names and trademarks

– A company’s value in the marketplace depends largely on current perceptions of future profitability.

– We can see it in the market value of the world’s most valuable product brands.

– Valuation depends on the market prices of shares of stock of a company times the number of shares traded.


Table 26-1 Values of the Top Ten Brands


Methods of Advertising

• Direct Marketing– Advertising targeted at specific consumers: e-

mail, regular mail

• Mass Marketing– Advertising intended to reach as many

customers as possible: radio, TV, newspaper

• Interactive Marketing– Permits consumer to follow up directly by

searching for more information


Figure 26-3 Distribution of U.S. Advertising Expenses

Sources: Advertising Today; Direct Marketing Today; and Internet Advertising Bureau.


Informational Versus Persuasive Advertising

• Search Good– A product with characteristics that enable an

individual to evaluate the product’s quality in advance of a purchase

• Experience Good– A product that an individual must consume

before the product’s quality can be established

• Credence Good– A product with qualities that consumers lack the

expertise to assess without assistance


Brand Names and Advertising

• Examples of search goods – Clothing and music evaluated prior to purchase

• Examples of experience goods– Soft-drinks, restaurants, movies

• Examples of credence goods– Health care, legal advice



• Informational Advertising– Advertising that emphasizes transmitting

knowledge about the features of a product

• Persuasive Advertising– Advertising that is intended to induce a

consumer to purchase a particular product and discover a previously unknown taste for an item



• Advertising as a signaling behavior

– Individual companies can explicitly engage in signaling behavior.

– They do so by establishing brand names or trademarks and promoting them.


Information Products and Monopolistic Competition

• Information products, such as computer operating systems, software, and digital music and videos, have a unique cost structure.

• Product development entails high fixed costs, but the marginal cost of producing a copy for one more customer is low.


Information Products and Monopolistic Competition (cont'd)

• Information Product

– An item that is produced using information-intensive inputs at a relatively high fixed cost but distributed for sale at a relatively low marginal cost


Figure 26-4 Cost Curves for a Producer of an Information Product

• TFC is $250,000• Producer sells 5,000 copies

AFC falls to $50 per copy• What is AFC if producer sells

50,000 copies?



• Short-Run Economies of Operation

– A distinguishing characteristic of an information product arising from declining short-run average total cost as more units of the product are sold



• Consider how computer game manufacturers operate in a monopolistically competitive market.

• In monopolistic competition, marginal cost pricing results in losses for the firm, even though it creates efficiencies for the economy as a whole.



• Providing an information product entails incurring relatively high fixed costs, but a relatively low per-unit cost for additional units of output.

• The ATC for a firm that sells an information product slopes downward, meaning the firm experiences short-run economies of operation.

• In a long-run monopolistically competitive equilibrium, price adjusts to equal ATC; the firm earns sufficient revenues to cover total costs, including the opportunity cost of capital. Consumers thereby pay the lowest price necessary to induce sellers to provide the item.


Figure 26-5 The Infeasibility of Marginal Cost Pricing of an Information Product

Firm cannot behave as if it were a perfect competitor setting price at $2.50


Issues and Applications: What’s in a Name? The Auto Name Game Heats Up

• The world’s auto companies now offer more than 80 different groups of automobile brands.

• In addition, within each group, there typically are several different models from which consumers can choose.

• All of this product differentiation has recently created a problem for automakers, however. They are running out of names to differentiate their vehicles from the pack.


Issues and Applications: What’s in a Name? The Auto Name Game Heats Up. (Cont’d)

• Today’s auto industry possesses all of the classic features of monopolistic competition: numerous producers, differentiated products, and considerable use of advertising.

• For decades, auto makers have struggled to come up with vehicle names that differentiate their products in the minds of consumers.

• As more manufacturers have jumped on the letter-number combination bandwagon, effective product differentiation has become increasingly difficult.


Issues and Applications: What’s in a Name? The Auto Name Game Heats Up. (Cont’d)

• What is automakers’ economic objective for coming up with new vehicle names on a regular basis?

• What do you suppose accounts for why names of products such as vehicles sometimes become similar but not quite the same, just as the actual products share analogous but not quite identical features?


Summary Discussion of Learning Objectives

• Key characteristics of a monopolistically competitive industry

– Large number of small firms

– Differentiated products

– Easy entry and exit

– Advertising and sales promotion


Summary Discussion of Learning Objectives (cont'd)

• Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms

– Monopolistically competitive firm in short run

• Produces output to point MR = MC in short run

• Price set on demand curve, can be less than MC and ATC in short run, firm earns economic profits



• Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms

– Monopolistically competitive firm in the long run

• Price = ATC in the long run as firms enter industry

• Like perfectly competitive firms, earns zero economic profits in long run

• Price exceeds MC in long run



• Monopolistically competitive firms attempt to boost demand for their products through product differentiation.

– They engage heavily in advertising and marketing.

• Providing an information product entails incurring relatively high fixed costs but low marginal costs.

– In the long run equilibrium, price adjusts to equality with average total cost.

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Chapter 26 Monopolistic Competition - …wps.pearsoncustom.com/wps/media/objects/9875/... · 26-28 Copyright © 2011 Pearson Education, Inc. All rights reserved. Comparing Perfect