Download Paul Krugman | Robin Wells

THIRD EDITION
ECONOMICS
and
MICROECONOMICS
Paul Krugman | Robin Wells
Chapter 15
Monopolistic Competition and Product Differentiation
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
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
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.
Product Differentiation
• How do firms in the same industry—such as fast-food
vendors, gas stations, or chocolate companies—differentiate
their products?
• Is the difference mainly in the minds of consumers or in the
products themselves?
Product Differentiation
There are three important forms of product differentiation:
1) Differentiation by style or type – sedans vs. SUVs
2) Differentiation by location – dry cleaner near home vs.
cheaper dry cleaner far away
3) Differentiation by quality – ordinary chocolate ($) vs.
gourmet chocolate ($$$)
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.
ECONOMICS IN ACTION
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 – the Model T.
• Alfred P. Sloan of GM challenged this strategy by offering a
range of car types, differentiated by quality and price,
including Chevrolet, Cadillac, and Buick.
• By the 1930s the verdict was clear: Customers preferred a
range of styles!
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 downward-sloping 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
product it can sell depends on the prices and products
offered by other firms in the industry.
The MC 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.
The MC Firm in the Short Run
Price,
cost,
marginal
revenue
Price,
cost,
marginal
revenue
(a) A Profitable Firm
MC
(b) An Unprofitable Firm
MC
ATC
P
P
ATC
ATC
U
P Loss
U
Profit
ATC
P
MR
P
Q
P
Profit-maximizing quantity
D
P
Quantity
MR
U
Q
U
D
U
Loss-minimizing quantity
Quantity
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 profit-maximizing output.
Entry and Exit Shift Existing Firm’s Demand Curve and
Marginal Revenue Curve
Price,
marginal
revenue
Price,
marginal
revenue
(a) Effects of Entry
Entry shifts the
existing firm’s
demand curve and its
marginal revenue
curve leftward.
MR
2
MR
1
D
2
D
1
Quantity
(b) Effects of Exit
Exit shifts the
existing firm’s
demand curve and
its marginal
revenue curve
rightward.
MR
1
MR D1
2
D
2
Quantity
FOR INQUIRING MINDS
HITS AND FLOPS
• On the face of it, the movie business seems to meet the
criteria for monopolistic competition.
• Movies compete for the same consumers; each movie is
different from the others; new companies can and do enter
the business.
 But where’s the zero-profit equilibrium? After all, some
movies are enormously profitable.
FOR INQUIRING MINDS
HITS AND FLOPS
• The key is to realize that for every successful blockbuster,
there are several flops—and that the movie studios don’t
know in advance which will be which.
• The difference between movie-making and the type of
monopolistic competition we model in this chapter is that
the fixed costs of making a movie are also sunk costs—once
they’ve been incurred, they can’t be recovered.
FOR INQUIRING MINDS
HITS AND FLOPS
• Yet, there is still, in a way, a zero-profit equilibrium.
 If movies on average were highly profitable, more studios
would enter the industry and more movies would be made.
 If movies on average lost money, fewer movies would be
made.
 In fact, as you might expect, the movie industry on average
earns just about enough to cover the cost of production—that
is, it earns roughly zero economic profit.
ECONOMICS IN ACTION
THE HOUSING BUST AND THE DEMISE OF THE 6%
COMMISSION
• A home owner looking to sell hires an agent, who lists the
house for sale and shows it to interested buyers.
 Correspondingly, prospective home buyers hire their own
agent to arrange inspections of available houses.
• Traditionally, agents were paid by the seller: a commission
equal to 6% of the sales price of the house, which the
seller’s agent and the buyer’s agent would split equally.
ECONOMICS IN ACTION
THE HOUSING BUST AND THE DEMISE OF THE 6%
COMMISSION
• The real estate brokerage industry fits the model of
monopolistic competition quite well: in any given local
market, there are many real estate agents, all competing
with one another, but the agents are differentiated by
location and personality, as well as by the type of home they
sell (some focus on condominiums, others on very
expensive homes, and so on).
ECONOMICS IN ACTION
THE HOUSING BUST AND THE DEMISE OF THE 6%
COMMISSION
• And the industry has free entry: it’s relatively easy for
someone to become a real estate agent (take a course and
then pass a test to obtain a license).
• But for a long time there was one feature that didn’t fit the
model of monopolistic competition: the fixed 6%
commission that had not changed over time and was
unaffected by the ups and downs of the housing market.
ECONOMICS IN ACTION
THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION
• But protecting the 6% commission was always an iffy
endeavor because any action by the brokerage industry to
fix the commission rate at a given percentage would run
afoul of antitrust laws.
• And by the early to mid-2000s, as the housing boom
intensified, discount brokers had appeared on the scene.
 But traditional agents refused to work with them.
ECONOMICS IN ACTION
THE HOUSING BUST AND THE DEMISE OF THE 6% COMMISSION
• So in 2005, the Justice Department sued the National
Association of Realtors, the powerful trade group of agents.
 Oversight by regulators and the housing market bust which
began in 2006 are hastening the demise of the non-negotiable
6% commission.
• With sellers forced to accept less for their houses than often
anticipated, pressure has built for agents to accept less as
well.
 By 2009, the average commission had fallen to 5.36%, and
agents are now offering to list properties on broker databases
for as little as a few hundred dollars.
The Long-Run Zero-Profit Equilibrium
Price, cost,
marginal revenue
MC
Point of tangency
A TC
Z
P
= ATC
MC
MC
MR
Q
MC
D
MC
MC
Quantity
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 unexploited.
 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.
Comparing LR Equilibrium in PC and MC
Price, cost,
marginal
revenue
Price, cost, (b) Long-Run Equilibrium in
Monopolistic Competition
marginal
revenue
(a) Long-Run Equilibrium
in Perfect Competition
MC
ATC
MC ATC
P = ATC
MC
MC
PPC = MC =
PC
ATC
PC
D =MR =P
PC
MC
MC
Q
PC
Minimum-cost output
Quantity
MR
MC
Q
MC
D
MC
Quantity
Minimum-cost output
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.
• Price exceeds marginal cost, so some mutually beneficial
trades are unexploited.
• 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.
Controversies About Product Differentiation
No discussion of product differentiation is complete without
spending at least a bit of time on the two related of
advertising and brand names.
The Role of Advertising
• In industries with product differentiation, firms advertise 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.
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.
ECONOMICS IN ACTION
Absolut Irrationality
• Vodka is aquavit, the most unsophisticated type of alcohol.
It is bland, with no taste, no smell, and many brands are
comparable.
• How then are products differentiated? Advertising!!!
• Consider Absolut vodka, whose magnetic advertising
campaign has led to huge popularity for their brand.
• In Sweden (where Absolut is made), the locals prefer
cheaper brands. This is because alcohol advertising is
against the law in Sweden.
VIDEO
 TED TALK: Malcolm Gladwell on spaghetti sauce:
http://www.ted.com/talks/malcolm_gladwell_on_spaghetti_s
auce.html
Summary
1. Monopolistic competition is a market structure in which
there are many competing producers, each producing a
differentiated product, and there is free entry and exit in
the long run.
Product differentiation takes three main forms: by style or
type, by location, or by quality.
2. Short-run profits will attract entry of new firms in the long
run. This reduces the quantity each existing producer sells
at any given price and shifts its demand curve to the left.
Short-run losses will induce exit by some firms in the long
run. This shifts the demand curve of each remaining firm to
the right.
Summary
3. In the long run, a monopolistically competitive industry is
in zero-profit equilibrium: at its profit-maximizing quantity,
the demand curve for each existing firm is tangent to its
average total cost curve.
There are zero profits in the industry and no entry or exit.
4. In long-run equilibrium, firms in a monopolistically
competitive industry sell at a price greater than marginal
cost.
They also have excess capacity because they produce less
than the minimum-cost output; as a result, they have
higher costs than firms in a perfectly competitive industry.
Summary
5. A monopolistically competitive firm will always prefer to
make an additional sale at the going price, so it will engage
in advertising to increase demand for its product and
enhance its market power.
Advertising and brand names that provide useful
information to consumers are economically valuable. But
they are economically wasteful when their only purpose is
to create market power. In reality, advertising and brand
names are likely to be some of both: economically valuable
and economically wasteful.
KEY TERMS
•
•
•
•
Monopolistic competition
Zero-profit equilibrium
Excess capacity
Brand name