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Week 6 – ECMC02 – Monopolistic Competition Midterm test Saturday, October 28 at 5 p.m. in Room SW-309 Format: See old tests on web site www.utsc.utoronto.ca/~cleveland 2 hour test Multiple choice Problems Theory questions 1 Today, Monopolistic Competition (or markets with differentiated products) Toothpaste, laundry detergent, instant coffee, breakfast cereals, colas, other soft drinks, cars, cameras…. -heavily advertised -focus on superior product characteristics We have studied: Perfect competition Monopoly Oligopoly - producers have similar or identical product - salt, paper clips, copy paper, oil, wheat, lumber, etc. Form of competition: - focus on product design, special features, safety, functionality, sex appeal - i.e., competition between “brands” 2 Entry to the market is not “blocked” Market power comes from appeal of product to consumers. (think iPod) Other brands are substitutes, but not perfect substitutes The more distinctive your product, the more market power over price you have. 3 How do we model product differentiation? Depends on how consumers view different brands of the product Two models: 1. Chamberlin model – all brands compete equally with each other. If new brand successfully enters the market, each other brand will lose equal amount of market share. (e.g., colas) 2. Hotelling model – competition among brands is localized. A new brand will compete only with other brands that are similar. Will not affect market share of brands that are not similar. (e.g., all bottled drinks) 4 Chamberlin Model - each firm faces downward-sloping demand curve for its product - each brand is an equal (not perfect) substitute for every other brand (in the consumer’s mind) - therefore, we assume they share market equally - each firm has some degree of monopoly (market) power – profit max where MC=MR Look at demand curve for representative firm (not industry demand curve!) 5 Price per unit quantity MC AC Brand Demand in Short Run MRSR 0 Quantity produced per unit of time 6 In the long run, new firms (brands) will see the profit opportunity and enter this market. Since other brands are equally attractive, they will equally lose market share Demand for the representative firm (brand) will shift to left until there is zero profit 7 Price per unit quantity MC AC Brand Demand in Short Run Brand Demand in Long Run MRSR 0 MRLR 8 Quantity produced per unit of time Compare to PC - Profit in SR Price > MC (therefore inefficiency) Excess capacity Zero profit but not min AC in LR Monopoly power small Inefficiency balanced against product diversity 9 Hotelling Model Brands are not identically related to each other. There is a clustering of brands. “Close” brands are better substitutes (think music genres). To represent the idea of “close” brands, Hotelling uses metaphor of distance. To fix ideas, consider the following: There is a beach one mile in length. Consumers come to the beach each day and spread themselves evenly along it. Ice cream vendors are considering where to locate. We assume ice cream from each vendor is identical, but vendors are differentiated by distance. In fact, vendors also charge exactly the same price to buy an ice cream. Consumers have preference for the “closest” brand. 10 We assume that every person on the beach wants one ice cream each day (never two, never zero). If there is only one ice cream vendor (and he knows there will never be another vendor), what is the profit-maximizing place to locate his cart along this one-mile beach? 11 If the first ice cream vendor is located at the centre of the beach, what is the profit-maximizing location for the second vendor (assuming both do not believe any other vendors will come along). 12 What is the most efficient possible location for two vendors along the beach? Why? What is the implication? 13 If two vendors are located in the optimum (most efficient) locations, where will a third vendor locate? How big will the market of this third vendor be? 14 What is the optimum location of three vendors along the beach? Why? 15 Imagine that the one-mile long beach was circular, with no end and no beginning. What is the optimum location for four vendors along the beach? Why? Draw this model. 16 Imagine a fifth vendor comes to this circular beach. What is the profit-maximizing location for this vendor? How big is this vendor’s market? 17 Explain how this “distance” metaphor, helps us to understand the nature of competition in a Hotelling-type monopolistically competitive market. How is this different from Chamberlin? 18 If you were a producer of breakfast cereals, with a knowledge of the Hotelling model, what might your business strategy be? 19 An algebraic example of a Hotelling-type model: Assume that each firm in a monopolistically competitive industry has a total cost of production function with some brand-specific costs (e.g, product development or advertising costs) so that TC = K + cY where Y = firm’s output K = set-up or brand development cost c = constant marginal cost Assume that consumers are evenly spaced around a circular market, and that each buys one unit of the good, and only one unit. Consumers prefer lowest “delivered” price (i.e, distance is what differentiates the product of each firm) 20 In the SR, there are a fixed number of firms, with distance L between each firm. In the LR, entry is possible (but incumbent firms have fixed locations because of set-up costs). Look at the situation of a representative firm (all firms are similar). Take a straightened-out portion of the circular market: P` P` PR -L x” 0 21 x’ + L The representative producer is located at 0 and charges price PR. Delivery cost to consumers is 1 per unit of distance. L is the distance to the next brand. As shown above, the representative producer will have the lowest delivered price in serving customers between x” and x’, so this is the representative producer’s market. We can use this information to calculate the demand function for this representative producer and determine what price it will charge and what short-run equilibrium will look like. 22 On the right hand side of the representative producer, PR + x’ = P` + (L – x’). In other words, delivered price will be equal at x’. Therefore, x’ = (P` + L - PR)/2. Logically, this same expression holds for x”, so if YR is the market for output of the representative firm, then YR = P` + L - PR. This says that the market for the representative firm depends on what price the neighbouring firms are charging, on the price the representative firm charges and on the distance between brands. This is a demand function; the inverse demand function is PR = P` + L - YR . The marginal revenue function for this representative firm is MR = P` + L - 2YR . Marginal cost is c, so profit maximizing output is given by P` + L - 2YR = c or YR* = (P` + L – c)/2. 23 We can calculate the profit-maximizing price as PR* = P` + L – [(P` + L – c)/2], or PR* = (P` + L + c)/2. Assuming all brands face the same marginal cost, and are equally spaced, they will choose the same profit-maximizing price, so in SR equilibrium PR = P`. Therefore, P* = L + c and Y* = [(L + c) + L – c]/2 = L. Profit of each firm will be TR – TC = L2 – K. 24 The Long Run In the long run there is free entry (no barriers to entry). Will entry of firms drive profits to zero, as it does in the perfectly competitive model and in the Chamberlin model of monopolistic competition? Given that brands are equally spaced, a new entrant can do no better than to locate exactly half-way between two brands. However, this means that the new entrant will have a market half the size of incumbent firms (L/2 rather than L). That means the demand curve for the incumbent firm will be YE = P + (L/2) – PE (two pages ago we had YR = P` + L - PR and this is the equivalent statement for the new entrant). But P (the prices charged by the incumbent firms) = L + c, so we can write YE = (L + c) + (L/2) – PE = 3/2 L + c - PE (which is the demand function for the new entrant’s output). 25 The inverse demand function for the output of the potential entrant is PE = 3/2 L + c - YE. Marginal revenue for the incumbent is MRE = 3/2 L + c - 2YE. Marginal cost is c, so the new entrant will profitmaximize when 3/2 L + c - 2YE = c or YE* = ¾ L and PE* = ¾ L + c. Therefore the profit of the potential entrant is TR – TC = (¾ L) x (¾ L + c) – (K + ¾ Lc) or profit = 9/16 L2 – K. This profit is less than the profit of the incumbent firms. The entrant’s profit will equal zero when 9/16 L2 – K = 0 or when L = 4/3 K1/2. L is the distance between firms, so this says that if incumbent brands are too close together then no profitable entry can occur. However, notice that when the entrant’s profit equals zero (i.e., when L = 4/3 K1/2), incumbent firms will still be earning profit = L2 – K = 16/9 K – K = 7/9 K. In other words, incumbent firms may still earn a considerable profit (7/9 K could be a large amount) while there is no profitable entry that is possible. 26