Micro Ch17 Lecnotes

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PowerPoint Lecture Notes for Chapter 17: Monopolistic Competition

Pri nciples of Microeconomics4th

edition, by N. Gregory Mankiw

PowerPoint Slides by Ron Cronovich

2007 Thomson South-Western, all rights reserved

N . G R E G O R Y M A N K I W

PowerPointSlidesby Ron Cronovich

17

P R I N C I P L E S O F

F O U R T H E D I T I O N

MICROECONOMICS

Monopolistic CompetitionMonopolistic Competition

Examples of monopolistic competition are everywhere: the clothesstudents where, the frappacinos they slurp up on their way to class orwork, the books they read, the nightclubs they dance at.

As a result, students find the theory of monopolistic competitionmore relevant than the theory of perfect competition, which bestdescribes produces like wheat and soybeans, products that fewstudents every consider buying.

If students are reasonably comfortable with the material on perfectcompetition and monopoly, then this chapter should not be difficult.It is also shorter than average.

CHAPTER 17 MONOPOLISTIC COMPETITION 1

In this chapter, look for the answers to

these questions:

How is monopolistic competition similar to perfectcompetition? How is it similar to monopoly?

How do monopolistically competitive firms choose

price and quantity? Do they earn economic profit?

In what ways does monopolistic competition affect

societys welfare?

What are the social costs and benefits of

advertising?


Introduction to Monopolistic Competition

Monopolistic competition:

a market structure in which many firms sell

products that are similar but not identical.

Examples:

apartments

books

bottled water

clothing

fast food

night clubs

Another important dimension of product differentiation, notemphasized in the book, is location. Gasoline seems like anundifferentiated product, yet different gas stations charge differentprices. How can some gas stations get away with charging 5 or even

10 cents more per gallon? The answer is product differentiation bylocation.

Imagine youre driving home in rush-hour traffic from a grueling 10-hour day at the office. The orange warning light comes on, indicatingyour car needs gas. After uttering a few choice expletives, you noticetwo gas stations at an upcoming intersection. The one on the rightcharges 5 cents more than the one on the left, but is easily accessible.The one on the left would require you to make a left-hand turn inheavy traffic to get into the station, and another to get out. And howmuch would you save? If you buy 20 gallons, youd save only $1.

Alternatively, imagine you run a gas station located in a highlyresidential area, in which there are few other businesses includinggas stations. If people want gas, they can buy it from you, or they candrive 10 minutes to a more commercial area with lots of gas stations.Your location allows you to charge a higher price.

Business people have long understood that location is a criticaldimension of product differentiation. Hence the saying location,location, location.


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Comparing Perfect & Monop. Competition

yesnone, price-takerfirm has market power?

downward-sloping

horizontalD curve facing firm

differentiatedidenticalthe products firms sell

zerozerolong-run econ. profits

yesyesfree entry/exit

manymanynumber of sellers

monopolistic

competition

perfect

competition

That long-run profits are zero follows from free entry/exit.

The market power of a monopolistic competitor follows from the factthat it sells a product that is at least somewhat different from productssold by other firms.


Comparing Monopoly & Monop. Competition

yesyesfirm has market power?

downward-sloping

downward-

sloping(market demand)

D curve facing firm

manynoneclose substitutes

zeropositivelong-run econ. profits

yesnofree entry/exit

manyonenumber of sellers

monopolistic

competitionmonopoly

For monopolistic competition, free entry/exit drives profits to zero inthe long run.

In contrast, barriers to entry prevent the monopolists profits frombeing driven to zero.

A monopoly is the sole seller of a product with no close substitutes.In contrast, the monopolistic competitor sells a product with manyclose substitutes. As a result, demand for the monopolists product isless elastic than demand for the monopolistic competitors product.


Comparing Oligopoly & Monop. Competition

highlowlikelihood of fierce

competition

lowhighimportance of strategic

interactions between firms

manyfewnumber of sellers

monopolistic

competitionoligopoly


profit

ATC

P

A Monopolistically Competitive FirmEarning Profits in the Short Run

The firm faces a

downward-sloping

D curve.

At each Q, MR< P.

To maximize profit,

firm produces Q

where MR= MC.

The firm uses the

D curve to set P.Quantity

Price

ATC

D

MR

MC

Q

The graphical analysis of the monopolistically competitive firmsoutput, price, and profits/losses is very similar to that of themonopoly firm.

One subtle difference is that the demand curve (and MR curve) facingthe monopolistically competitive firm is likely to be flatter than the

demand curve facing the monopolist, as the monopolistic competitorfaces competition from other firms selling similar products.


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losses

A Monopolistically Competitive FirmWith Losses in the Short Run

For this firm,

P MC.

Under perfect competition, P= MC.

Due to the markup of price over marginal cost, the market outputunder monopolistic competition will be smaller than the sociallyefficient output, as we discuss on the following slide.


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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.

Yet, not easy for policymakers to fix this problem:

Firms earn zero profits, so cannot require them

to reduce prices.

The problem facing policymakers here is similar to the problemarising from natural monopoly: With natural monopoly, ATC isalways falling, so MC is below ATC. If regulators force a naturalmonopoly to price at marginal cost, it will incur losses.


Monopolistic Competition and Welfare

Number of firms in the market may not be optimal,

due to external effects from the entry of new firms:

the product-variety externality:

surplus consumers get from the introduction

of new products

the business-stealing externality:

losses incurred by existing firms

when new firms enter market

The inefficiencies of monopolistic competition aresubtle and hard to measure. No easy way for

policymakers to improve the market outcome.

One of these externalities is positive, the other is negative. Its notclear which one is bigger, and it may in fact differ by industry.


Advertising

In monopolistically competitive industries,

product differentiation and markup pricing

lead naturally to the use of advertising.

In general, the more differentiated the products,

the more advertising firms buy.

Economists disagree about the social value of

advertising.

This section of the textbook has a nice FYI box contrasting the viewson advertising of John Kenneth Galbraith and Frederic Hayek, two ofthe great economists of the 20th century.


The Critique of Advertising

Critics of advertising believe:

Society is wasting the resources it devotes to

advertising.

Firms advertise to manipulate peoples tastes.

Advertising impedes competition

it creates the perception that products are

more differentiated than they really are,allowing higher markups.


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The Defense of Advertising

Defenders of advertising believe:

It provides useful information to buyers.

Informed buyers can more easily find and

exploit price differences.

Thus, advertising promotes competition and

reduces market power.

Results of a prominent study:

Eyeglasses were more expensive in states

that prohibited advertising by eyeglass makersthan in states that did not restrict such advertising.

The study mentioned here was by economist Lee Benham, publishedin theJournal of Law and Economics in 1972. The textbook has acase study that discusses this research in more detail.


Advertising as a Signal of Quality

A firms willingness to spend huge amounts

on advertising may signal the quality of its product

to consumers, regardless of the content of ads .

Ads may convince buyers to try a product once,

but the product must be of high quality for people

to become repeat buyers.

The most expensive ads are not worthwhile

unless they lead to repeat buyers.

When consumers see expensive ads,they think the product must be good if the company

is willing to spend so much on advertising.


Brand Names

In many markets, brand name products coexist

with generic ones.

Firms with brand names usually spend more on

advertising, charge higher prices for the products.

As with advertising, there is disagreement about

the economics of brand names


The Critique of Brand Names

Critics of brand names believe:

Brand names cause consumers to perceive

differences that do not really exist.

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.


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The Defense of Brand Names

Defenders of brand names believe:

Brand names provide information about quality

to consumers.

Companies with brand names have incentive

to maintain quality, to protect the reputation of

their brand names.


CONCLUSION

Differentiated products are everywhere;

examples of monopolistic competition abound.

The theory of monopolistic competition

describes many markets in the economy,

yet offers little guidance to policymakers looking

to improve the markets allocation of resources.


CHAPTER SUMMARY

A monopolistically competitive market has

many firms, differentiated products, and free entry.

Each firm in a monopolistically competitive market

has excess capacity produces less than the

quantity that minimizesATC. Each firm charges a

price above marginal cost.


CHAPTER SUMMARY

Monopolistic competition does not have all of the

desirable welfare properties of perfect competition.

There is a deadweight loss caused by the markup

of price over marginal cost. Also, the number of

firms (and thus varieties) can be too large or too

small. There is no clear way for policymakers to

improve the market outcome.


CHAPTER SUMMARY

Product differentiation and markup pricing lead to

the use of advertising and brand names. Critics of

advertising and brand names argue that firms use

them to reduce competition and take advantage of

consumer irrationality. Defenders argue that firms

use them to inform consumers and to compete

more vigorously on price and product quality.

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Micro Ch17 Lecnotes