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CHAPTER 16 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 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, and there is free entry into and exit from the industry in the long run. 3 Product Differentiation Product differentiation plays an even more crucial role in monopolistically competitive industries. Why? Tacit collusion: is it possible? Product differentiation market power. Then, how do firms in the same industry differentiate their products? E.g. hotels in Vung Tau Is the difference mainly in the minds of consumers or in the products themselves? 4 Product Differentiation There are three important forms of product differentiation: Differentiation by style or type SUV’s – Sedans vs. Differentiation by location – hair-dressers near home vs. Cheaper hair-dressers far away Differentiation by quality – Ordinary ($) vs. gourmet chocolate ($$$) 5 Product Differentiation Whatever form it takes, however, there are two important features of industries with differentiated products: Competition among sellers: entry by more producers reduces the quantity each existing producer sells Value in diversity: consumers gain from the increased diversity of products. 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! 7 Understanding Monopolistic Competition Combines some features typical of monopoly with others typical of perfect competition: Each firm is offering a distinct product like a monopolist (downward-sloping demand curve & has some market power) Unlike a pure monopolist, a monopolistically competitive firm does face competition. 8 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 profit-maximizing 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. 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 9 results in a greater loss. 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. 10 Entry and Exit into the Industry Shift 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. 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 11 rises. Exit will cease when the remaining firms make zero profit. 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 profitmaximizing output level: at the profit-maximizing output level, 12 QMC, price, PMC, equals average total cost, ATCMC. 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. 13 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 . 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 14 capacity. 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. 15 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 16 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. 17 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. 18