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Imperfect Competition Continued

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Monopolistic Competition

Many sellers

Product differentia

tion each firm produces a slightly different versionof product

each has a monopoly on differentiated product

Free entry into industry drives profit to zero in long run

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Short-Run Equilibrium

Just like monopoly

Faces downward sloping demand and MR Maximizes profit by producing quantity at

which MC=MR

Enjoys economic profit if, at equilibrium,P>AC

Suffers loss if, at equilibrium, P

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$

0 Output

D, AR

MR

ACMC

Qe

Pe

ACe

Loss

Monopolistic Competition with

Short-Run Loss

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$

0 Output

D, AR

MR

AC

MC

Qe

PeACe=

Monopolistic Competition in

Long-Run Equilibrium

Zero profit

MCe

In equilibrium, P>MC

and the firm is NOToperating at the

minimum point of its

AC curve. For both

reasons, monopolistic

competition is notefficient.

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Characteristics of Equilibrium

Just as in the monopoly case, price exceeds

marginal cost in the short and long run

efficiency requires price to equal marginal cost

Just as with perfect competition, firms may

earn either positive or negative profits in the

short run but in the long run profits are zero

In the long run, there is excess capacity

the firm produces less than that which would

minimize costs

not efficient

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Advertising

Because price exceeds marginal cost, these

firms would love to sell more

the problem is that selling more requires lowering

the price unless more consumers decide to buy at the current price

The trick is to advertise

advertising increases demand

the demand curve AND marginal revenue curve shift

also creates brand loyalty

makes demand less elastic

increases markup of price over marginal cost

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The Debate over Advertising

The cons

waste of resources to make consumers think

they want something they dont really want

makes consumers think that there are

differences that dont really exist

impedes competition makes demand less elastic

increases inefficient markup of price over marginal cost

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The pros

increases competition by providing information

to consumers

price differences

location

new products

without advertising, it would be very difficult for new

firms to enter

advertising signals quality

even when nothing is said about quality in the ad!

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The Competitive Effects of

Advertising

Advertising impedes competition by

making demand less elastic

Advertising promotes competition byproviding information

The net effect appears to be pro-competitive

professionals like doctors, optometrists, andlawyers try to get state governments to prohibit

advertising as unprofessional

prices substantially lower when advertising

allowed

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Case Study: Advertisingand eyeglasses in 1960s, states varied considerably on laws

concerning advertising of eyeglasses

provided natural experiment of effect on prices

prohibition ofadvertising associated with 20%

higher prices

in 1970s, Florida repealed its ban on advertising

prices plummeted

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Advertising as aSignal of

Quality

Advertising can be very expensive

The willingness of firms to spend a lot on

ads with famous movie or sports stars is a

signal to consumers that they think their

product is good

firms that know their products are mediocre

will not be as willing to invest massively on aproduct that is likely to be rejected by

consumers

consumers are then rationally more likely to try

products that are expensively advertised

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The Effects of Brand Names

Are the resources that go into maintaining a

brand name a waste?

is there rea

llya

ny difference between Ba

yerand generic aspirin?

In many cases, society gets real benefits

gives consumers information about quality

when quality cannot be easily determined inadvance of purchase

gives producers strong incentive to maintain

quality to protect brand name

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Consider what happens when you pull offa

highway looking for something to eat theres Joes Dinerand McDonalds

most will pickMcDonalds because they know

exactly what they will get there and they have

no idea what they will get at Joes Diner

quality assurance is valuable to consumers

this brand identification is valuable to firms

M

cDona

lds will investa

lot to ma

inta

in it food poisoning at one store would be hugely costly to itsreputation

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Summary ofMarket Structures

Number of firms

Monopolyutilities

cable TV

Microsoft???

Oligopolycrude oil

autos

golf balls

One

firm Fewfirms

Product

Monopolistic

Competitioncereal

OTC drugs

toothpaste

PerfectCompetitionwheat

beef

nails

Differentiated Identical