Download Lecture5.MonopolisticCompetition.2006_000

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
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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”
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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.
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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)
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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!)
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Price
per unit
quantity
MC
AC
Brand
Demand
in Short
Run
MRSR
0
Quantity
produced
per unit of
time
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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
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Price
per unit
quantity
MC
AC
Brand
Demand
in Short
Run
Brand
Demand
in Long
Run
MRSR
0
MRLR
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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
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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.
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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?
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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).
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What is the most efficient possible location for
two vendors along the beach? Why? What is the
implication?
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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?
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What is the optimum location of three vendors
along the beach? Why?
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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.
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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?
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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?
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If you were a producer of breakfast cereals, with
a knowledge of the Hotelling model, what might
your business strategy be?
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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)
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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
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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.
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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.
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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.
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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).
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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.
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