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CHAPTER 16 Monopolistic Competition and Product Differentiation PowerPoint® Slides by Can Erbil and Gustavo Indart © 2005 Worth Publishers © 2005 Worth Publishers, all rights reserved Slide 16-1 What You Will Learn in this Chapter: The meaning of monopolistic competition Why oligopolists and monopolistically competitive firms differentiate their products How prices and profits are determined in monopolistic competition in the short run and the long run Why monopolistic competition poses a trade-off between lower prices and greater product diversity The economic significance of advertising and brand names © 2005 Worth Publishers Slide 16-2 The Meaning of Monopolistic Competition Monopolistic competition is a market structure in which there are many competing producers in an industry each producer sells a differentiated product there is free entry into and exit from the industry in the long run © 2005 Worth Publishers Slide 16-3 Product Differentiation Product differentiation plays an even more crucial role in monopolistically competitive industries. Why? Tacit collusion is virtually impossible when there are many producers. Hence, product differentiation is the only way monopolistically competitive firms can acquire some market power. Then, how do firms in the same industry—such as fastfood vendors, gas stations, or chocolate companies— differentiate their products? Is the difference mainly in the minds of consumers or in the products themselves? © 2005 Worth Publishers Slide 16-4 Product Differentiation There are three important forms of product differentiation: Differentiation by style or type – Sedans vs. SUV’s Differentiation by location – Dry cleaner near home vs. cheaper dry cleaner far away Differentiation by quality – Ordinary ($) vs. gourmet chocolate ($$$) © 2005 Worth Publishers Slide 16-5 Product Differentiation Whatever form it takes, however, there are two important features of industries with differentiated products: Competition among sellers: Producers compete for the same market, so entry by more producers reduces the quantity each existing producer sells at any given price Value in diversity: In addition, consumers gain from the increased diversity of products © 2005 Worth Publishers Slide 16-6 Economics in Action: Case: “Any Color, So Long as It’s Black” Ford’s strategy was to offer just one style of car, which maximized his economies of scale but made no concessions to differences in taste Model T Alfred P. Sloan of GM challenged this strategy by offering a range of car types, differentiated by quality and price Chevrolet, Cadillac, Buick… By the 1930s the verdict was clear: Customers preferred a range of styles! © 2005 Worth Publishers Slide 16-7 Understanding Monopolistic Competition As the term monopolistic competition suggests, this market structure combines some features typical of monopoly with others typical of perfect competition: Because each firm is offering a distinct product, it is in a way like a monopolist: it faces a downwardsloping demand curve and has some market power—the ability within limits to determine the price of its product However, unlike a pure monopolist, a monopolistically competitive firm does face competition: the amount of its product it can sell depends on the prices and products offered by other firms in the industry © 2005 Worth Publishers Slide 16-8 Understanding Monopolistic Competition: The Monopolistically Competitive Firm in the Short Run The following figure shows two possible situations that a typical firm in a monopolistically competitive industry might face in the short run. In each case, the firm looks like any monopolist: it faces a downward-sloping demand curve, which implies a downward-sloping marginal revenue curve We assume that every firm has an upward-sloping marginal cost curve, but that it also faces some fixed costs, so that its average total cost curve is U-shaped © 2005 Worth Publishers Slide 16-9 Short-Run Equilibrium The firm in panel (a) can be profitable for some output levels: the levels at which its ATC lies below its demand curve, DP. The profitmaximizing output level is QP, the output at which marginal revenue, MRP, is equal to marginal cost. The firm charges price PP and earns a profit, represented by the area of the shaded rectangle. © 2005 Worth Publishers The firm above can never be profitable because the ATC lies above its demand curve, DU. The best that it can do if it produces at all is to produce output QU and charge PU. This generates a loss, indicated by the area of the shaded rectangle. Any other output level results in a greater loss. Slide 16-10 Monopolistic Competition in the Long Run If the typical firm earns positive profits, new firms will enter the industry in the long run, shifting each existing firm’s demand curve to the left If the typical firm incurs losses, some existing firms will exit the industry in the long run, shifting the demand curve of each remaining firm to the right In the long run, equilibrium of a monopolistically competitive industry, the zero-profit-equilibrium, firms just break even The typical firm’s demand curve is just tangent to its average total cost curve at its profitmaximizing output © 2005 Worth Publishers Slide 16-11 Entry and Exit into the Industry Shifts the Demand Curve of Each Firm Entry will occur in the long run when existing firms are profitable. In panel (a), entry causes each firm’s demand curve and marginal revenue curve to shift to the left. The firm receives a lower price for every unit it sells, and its profit falls. Entry will cease when remaining firms make zero profit. © 2005 Worth Publishers Exit will occur in the long run when existing firms are unprofitable. In panel (b), exit out of the industry shifts each remaining firm’s demand curve and marginal revenue curve to the right. The firm receives a higher price for every unit it sells, and profit rises. Exit will cease when the remaining firms make zero profit. Slide 16-12 The Long-Run Zero-Profit Equilibrium A monopolistically competitive firm is like a monopolist without monopoly profits. If existing firms are profitable, entry will occur and shift each firm’s demand curve leftward. If existing firms are unprofitable, each firm’s demand curve shifts rightward as some firms exit the industry. In long-run zero-profit equilibrium, the demand curve of each firm is tangent to its average total cost curve at its profit-maximizing output level: at the profit-maximizing output level, QMC, price, PMC, equals average total cost, ATCMC. © 2005 Worth Publishers Slide 16-13 Monopolistic Competition versus Perfect Competition In the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit Price exceeds marginal cost, so some mutually beneficial trades are exploited The following figure compares the long-run equilibrium of a typical firm in a perfectly competitive industry with that of a typical firm in a monopolistically competitive industry © 2005 Worth Publishers Slide 16-14 Long-Run Equilibrium Panel (a) shows the situation of the typical firm in long-run equilibrium in a perfectly competitive industry. The firm operates at the minimum-cost output QC , sells at the competitive market price PC , and makes zero profit. It is indifferent to selling another unit of output because PC is equal to its marginal cost, MCC . © 2005 Worth Publishers Panel (b) shows the situation of the typical firm in long-run equilibrium in a monopolistically competitive industry. At QMC it makes zero profit because its price, PMC, just equals average total cost. At QMC, the firm would like to sell another unit at price PMC, since PMC exceeds marginal cost, MCMC. But it is unwilling to lower price to make more sales. It therefore operates to the left of the minimum-cost output and has excess capacity. Slide 16-15 Is Monopolistic Competition Inefficient? Firms in a monopolistically competitive industry have excess capacity: they produce less than the output at which average total cost is minimized The higher price consumers pay because of excess capacity is offset to some extent by the value they receive from greater diversity Hence, it is not clear that this is actually a source of inefficiency © 2005 Worth Publishers Slide 16-16 Controversies About Product Differentiation No discussion of product differentiation is complete without spending at least a bit of time on the two related issues—and puzzles—of: advertising and brand names © 2005 Worth Publishers Slide 16-17 The Role of Advertising In industries with product differentiation, firms advertise in order to increase the demand for their products Advertising is not a waste of resources when it gives consumers useful information about products Advertising that simply touts a product is harder to explain Either consumers are irrational, or expensive advertising communicates that the firm's products are of high quality © 2005 Worth Publishers Slide 16-18 Brand Names Some firms create brand names A brand name is a name owned by a particular firm that distinguishes its products from those of other firms As with advertising, the social value of brand names can be ambiguous The names convey real information when they assure consumers of the quality of a product © 2005 Worth Publishers Slide 16-19 The End of Chapter 16 Coming Attraction: Chapter 17: International Trade © 2005 Worth Publishers Slide 16-20