After studying this chapter you will be 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
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PC War Games Globalization brings enormous diversity in
products and thousands of firms seek to make their own product
special and different from the rest of the pack. Dell,
Hewlett-Packard, Lenovo, Acer, and Toshiba accounted for one half
of the global market of $60 million PCs in 2006. 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?
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What Is 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.
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What Is 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 firms actions directly affect the
actions of other firms. Collusion, or conspiring to fix prices, is
impossible.
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What Is 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.
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What Is 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.
Slide 8
What Is 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. Examples of Monopolistic
Competition Figure 13.1 on the next slide shows market share of the
largest four firms and the HHI for each of ten industries that
operate in monopolistic competition.
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What Is Monopolistic Competition? Figure 13.1 shows examples.
The 4 largest firms. Next 4 largest firms. Next 12 largest firms.
The numbers are the HHI.
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Price and Output in Monopolistic Competition The Firms
Short-Run Output and Price Decision 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 set at the highest price the firm
can charge for the profit-maximizing quantity. The price is
determined from the demand curve for the firms product.
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Price and Output in Monopolistic Competition Figure 13.2 shows
a short-run equilibrium for a firm in monopolistic competition. It
operates much like a single-price monopoly.
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Price and Output in Monopolistic Competition The firm produces
the quantity at which marginal revenue equals marginal cost and
sells that quantity for the highest possible price. It makes an
economic profit (as in this example) when P > ATC.
Slide 15
Price and Output in Monopolistic Competition Profit Maximizing
Might be Loss Minimizing A firm might incur an economic loss in the
short run. Here is an example. In this case, P < ATC.
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Price and Output 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 make an economic
profitas 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.
Slide 18
Price and Output 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.
Slide 19
Price and Output in Monopolistic Competition Figure 13.4 shows
a firm in monopolistic competition in long-run equilibrium. If
firms incur an economic loss, firms exit to achieve the long-run
equilibrium.
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Price and Output in Monopolistic Competition Monopolistic
Competition and Perfect Competition Two key differences between
monopolistic competition and perfect competition are: Excess
capacity Markup A firm has excess capacity if it produces less than
the quantity at which ATC is a minimum. A firms markup is the
amount by which its price exceeds its marginal cost.
Slide 22
Price and Output in Monopolistic Competition Excess Capacity
Firms in monopolistic competition operate with excess capacity in
long- run equilibrium. The downward-sloping demand curve for their
products drives this result.
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Price and Output in Monopolistic Competition Markup Firms in
monopolistic competition operate with positive mark up. Again, the
downward- sloping demand curve for their products drives this
result.
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Price and Output in Monopolistic Competition In contrast, firms
in perfect competition have no excess capacity and no markup. The
perfectly elastic demand curve for their products drives this
result.
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Price and Output in Monopolistic Competition Is Monopolistic
Competition Efficient Because in monopolistic competition P >
MC, marginal benefit exceeds marginal cost. So monopolistic
competition seems to be inefficient. But the markup of price above
marginal cost arises from product differentiation. People value
variety but variety is costly. Monopolistic competition brings the
profitable and possibly efficient amount of variety to market.
Slide 29
Product Development and Marketing Innovation and Product
Development Weve looked at a firms profit-maximizing output
decision in the short run and the long run of a given product and
with given marketing effort. To keep making 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.
Slide 30
Product Development and Marketing Profit-Maximizing Product
Innovation Innovation is costly, but it increases total revenue.
Firms pursue product development until the marginal revenue from
innovation equals the marginal cost of innovation.
Slide 31
Product Development and Marketing Efficiency and Product
Innovation Marginal social benefit of an innovation is the increase
in the price that people are willing to pay for the innovation.
Marginal social cost is the amount that the firm must pay to make
the innovation. Profit is maximized when marginal revenue equals
marginal cost. In monopolistic competition, price exceeds marginal
revenue, so the amount of innovation is probably less than
efficient.
Slide 32
Product Development and Marketing Advertising Firms in
monopolistic competition incur heavy advertising expenditures.
Figure 13.6 shows estimates of the percentage of sale price for
different monopolistic competition markets. Cleaning supplies and
toys top the list at almost 15 percent.
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ATCAFCAVC Manufacturer (Asia) Materials9.00 Cost of labor2.75
Cost of capital3.00 Profit1.75 Shipping0.50 Import duties3.00 Nike
(Beaverton, Oregon) Sales, distribution, and administration5.00
Advertising4.00 Research and development0.25 Nike's profit6.25
Retailer (your town) Sales clerks wages9.50 Shop rent9.00 Retailers
other costs7.00 Retailer's profit9.00 Totals$70.00$6.50$63.50
Slide 35
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 firms product.
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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 $60.
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Product Development and Marketing The advertising expenditure
shifts the average total cost curve upward. With advertising, the
firm produces 100 units of output at an average total cost of $40.
The firm operates at a higher output and lower average total cost
than it would without advertising.
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Product Development and Marketing Selling Costs and Demand In
Figure 13.8(a), with no advertising, demand is not very elastic and
the markup is large. In Figure 13.8(b), advertising makes demand
more elastic, increases the quantity and lowers the price and
markup.
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Product Development and Marketing Using Advertising to Signal
Quality Why do Coke and Pepsi spend millions of dollars a month
advertising products that everyone knows? One answer is that these
firms use advertising to signal the high quality of their products.
A signal is an action taken by an informed person or firm to send a
message to uninformed persons.
Slide 43
Product Development and Marketing For example, Coke is a high
quality cola and Oke is a low quality cola. If Coke spends millions
on advertising, people think Coke must be good. If it is truly
good, when they try it, they will like it and keep buying it. If
Oke spends millions on advertising, people think Oke must be good.
If it is truly bad, when they try it, they will hate it and stop
buying it.
Slide 44
Product Development and Marketing So if Oke knows its product
is bad, it will not bother to waste millions on advertising it. And
if Coke knows its product is good, it will spend millions on
advertising it. Consumers will read the signals and get the correct
message. None of the ads need mention the product. They just need
to be flashy and expensive.