Download 26 – Monopolistic Competition

Chapter 26
Monopolistic Competition
Overview
In this chapter the model of monopolistic competition is discussed. Its key characteristics are defined, and the profit-maximizing rate
of output and long-run implications for efficiency with the perfect competition model are analyzed. The purpose and effect of
advertising, an important characteristic of monopolistic competition, is also discussed. The nature and purpose of product
differentiation is analyzed, with special attention to the use of brand names and advertising. Finally information products and
monopolistic
competition are presented.
Outline
I.
Monopolistic Competition: A market structure where a large number of firms produce similar but differentiated products,
which they advertise and promote. There is relatively easy entry into the
industry.
A.
Number of Firms: In monopolistic competition, there is a large number of firms, but not as many as in perfect competition.
This fact has several implications for a monopolistically
competitive industry.
1.
Small Share of Market: When many firms exist in an industry each firm has a relatively small share of the total market.
2.
Lack of Collusion: With many firms it is difficult for them to get together to collude; that is, to agree to cooperate to set a
pure monopoly price and output. Price rigging in a monopolistically competitive industry is virtually impossible.
3.
Independence: Because there are so many firms, each one acts independently of the others; no firm attempts to take into
account all of its rival firms.
B.
Product Differentiation: Product differentiation is the distinguishing of products by brand name, color, minor attributes, and
the like. Product differentiation occurs in other than perfectly competitive markets where products are homogeneous. Each separate,
differentiated product has numerous similar but not perfect substitutes. The greater the number of substitutes available, other things
being equal, the greater the price elasticity of demand. The ability of a firm to raise price is limited, and the demand curve slopes
downward.
C.
Sales Promotion and Advertising: No individual firm in a perfectly competitive market will advertise. It can sell all it wants
at the going market price. Since the monopolistic competitor has some monopoly power, advertising may result in increased profits.
Advertising should be carried to the point where marginal revenue advertising equals the marginal cost of advertising.
D.
Ease of Entry: For a monopolistic competitor, potential competition is always a threat. The easier and less costly entry is, the
more a current monopolistic competitor must worry about losing business.
II.
Price and Output for the Monopolistic Competitor (See Figure 26—1.)
A.
The Individual Firm’s Demand and Cost Curves: Since the individual firm is not a perfect competitor its demand curve
slopes downward. It faces a marginal revenue curve that is downward sloping and below the demand curve. The profit-maximizing
rate of output and price is determined by the intersection of the marginal cost and marginal revenue curves.
B.
Short-Run Equilibrium: In the short-run it is possible for a monopolistic competitor to make economic profits, normal profits,
or economic losses.
C
The Long-Run: Zero Economic Profits: In the long-run, because so many competitors produce substitutes any economic
profits will disappear with competition. They will be reduced to zero either through entry by new firms seeking a chance to make
economic profits or by changes in product quality and advertising outlays by existing firms in the industry. Economic losses in the
short-run will disappear in the long-run because firms that suffer them leave the industry. In the long-run the rate of return will tend
toward normal and economic profits will tend toward zero.
III.
Comparing Perfect Competition with Monopolistic Competition: Both the monopolistic competitor and the perfect
competitor make zero economic profits in the long run. The perfect competitor’s average total cost is at minimum in the long run. For
the monopolistic competitor the output is to the left of the minimum ATC, and price is greater than marginal cost. (See Figure 26—2.)
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IV.
Brand Names and Advertising: Because “differentness” has value to consumers, monopolistically competitive firms view
their brand names as valuable. Firms advertise their brand to maintain differentiation of their products from those of other firms.
A.
Brand Names and Trademarks: A firm’s value in the marketplace depends largely on its current profitability and perceptions
of its future profitability. (See Table 26—1.)
B.
Advertising: To help ensure that consumers differentiate their products from those of other firms, monopolistically
competitive firms engage in advertising.
1.
Methods of Advertising: Advertising can be in the form of direct marketing, mass marketing, or interactive marketing.
2.
Informational versus Persuasive Advertising: Informational advertising transmits knowledge about features of a product and
is more likely to be used with a search good. Persuasive advertising is advertising that is intended to alter a consumer’s tastes and
preferences and induce a consumer to purchase a particular product. It is more likely to be used with an experience good. Both
promotional and persuasive advertising are likely to be used with credence goods which are difficult for consumers to evaluate
without help.
3.
Advertising as Signaling Behavior: Signals are compact gestures or actions that convey information. Heavy advertising
expenditures that establish brand names or trademarks are signals that the company plans to stay in business.
V.
Information Products and Monopolistic Competition: A product produced using information intensive inputs at a relatively
high fixed cost but distributed for sale at a relatively low marginal cost is an information product.
A.
Special Cost Characteristics of Information Products: Creating the first unit of an information product such as a computer
program entails a high initial up-front cost. Additional units are very inexpensive to produce.
1.
Costs of Producing Information Products: High up-front costs of producing the first unit are fixed costs. All subsequent costs
of producing additional units are very low.
2.
Cost Curves for an Information Product: The larger is the number of units of an information product that is sold, the lower is
average fixed cost. Thus the average fixed cost curve slopes downward over the entire range of possible outputs. Average variable cost
is likely to be constant and thus marginal cost is likely to be constant. The average total cost curve will slope downward so producers
of information products experience short-run economies of operation. This sets information products apart from most other goods and
services. (See Figure 26—4.)
3.
Short-Run Economies of Operation: A distinguishing characteristic of an information product arising from declining shortrun average total cost as more units of the product are sold.
B.
Monopolistic Competition and Information Products (See Figure 26—5.)
1.
Marginal Cost Pricing and Information Products: Short-run economies of operation imply a continuously decreasing average
total cost curve over the relevant range of output. Marginal cost would be below the average total cost curve at all levels of output. If a
firm engages in marginal cost pricing it will incur economic losses. (See Figure 25—5, Panel (a).)
2.
The Case in Which Price Equals Average Total Cost: In the long-run after all entry and exit has occurred, the
monopolistically competitive firm will sell at a price equal to long-run average cost and economic profits will be zero. (See Figure
25—5, Panel (b).)
3.
Long-Run Equilibrium for an Information Product Industry: When the price of an information industry product equals
average total cost, sellers charge the minimum price that covers their costs including the high initial costs they paid to develop their
products. Buyers pay the lowest price that induces sellers to provide the item. (See Figure 25—5, Panel (b).)
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