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Chapter 25 Monopolistic Competition Introduction John Locke is the author of crime-adventure e-books selling for 99 cents at Amazon’s website. When he saw that successful authors were charging $9.99 for their ebooks, he expressed a confidence that he would have customers who feel that the other books are not necessarily ten times better than his. E-books are an example of a product that exhibits product differentiation, a fundamental characteristic of monopolistic competition. In this chapter, you will learn why the growing importance of e-books has complicated the process of selling both e-books and physical books. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-2 Learning Objectives • Discuss the key characteristics of a monopolistically competitive industry • Contrast the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-3 Learning Objectives (cont'd) • Explain why brand names and advertising are important features of monopolistically competitive industries • Describe the fundamental properties of information products and evaluate how the prices of these products are determined under monopolistic competition Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-4 Chapter Outline • Monopolistic Competition • Price and Output for the Monopolistic Competitor • Comparing Perfect Competition with Monopolistic Competition • Brand Names and Advertising • Information Products and Monopolistic Competition Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-5 Did You Know That … • A company called J & D Foods offers baconflavored and turkey-and-gravy-flavored soft drinks? • And you can buy bottled water in flavors of Buffalo wings, cheeseburger, and fish and chips? • Product heterogeneity, variations in product characteristics, and advertising did not show up in our analysis of perfect competition. • These are features of monopolistic competition— the subject of this chapter. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-6 Monopolistic Competition • In the 1920s and 1930s, economists were aware of industries that did not fit under perfect competition or pure monopoly • Theoretical and empirical research was instituted to develop some sort of middle ground Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-7 Monopolistic Competition (cont'd) • Two separately developed models of monopolistic competition resulted • At Harvard, Edward Chamberlin published Theory of Monopolistic Competition in 1933 • That same year, Joan Robinson of Cambridge published The Economics of Imperfect Competition Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-8 Monopolistic Competition (cont'd) • Monopolistic Competition – A market situation in which a large number of firms produce similar but not identical products – Entry into the industry is relatively easy Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-9 Monopolistic Competition (cont'd) • Characteristics of monopolistic competition 1. Significant numbers of sellers in a highly competitive market 2. Differentiated products 3. Sales promotion and advertising 4. Easy entry of new firms in the long run Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-10 Monopolistic Competition (cont'd) • Implications of the large number of firms 1. Small market share 2. Lack of collusion 3. Independence Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-11 Monopolistic Competition (cont'd) • Product Differentiation – The distinguishing of products by brand name, color, and other minor attributes. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-12 Monopolistic Competition (cont'd) • Product differentiation and price – The firm has some control over the price it charges – Unlike a perfect competitor, it faces a downward sloping demand curve – Consider the abundance of brand names for many products • The more successful the firm is at differentiation, the more control it has over price Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-13 Example: Is Punxsutawny Phil Hogging Too Much Attention? • Since 1887, Punxsutawny Phil, the groundhog residing in the Pennsylvania town of that name, has been used to predict the weather on February 2—the official Groundhog Day. • Today, there are at least 17 “groundhog lodges” in Pennsylvania and nearby states, each of which promotes its own groundhog’s weather-forecasting talents in an effort to attract tourists to their communities. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-14 Monopolistic Competition (cont'd) • What do you think about advertising? – Would a perfect competitor have any incentive to advertise? – Why would a monopolistically competitive firm advertise? – Can advertising lead to efficiency? Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-15 Monopolistic Competition (cont'd) • Sales promotion and advertising – Can increase demand for a firm – Can differentiate a firm’s product – Can result in increased profits Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-16 Monopolistic Competition (cont'd) • Question – How much advertising should be undertaken? • Answer – It should be carried to the point at which the additional revenue from one more dollar of advertising just equals that one dollar of additional cost Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-17 Example: A Biodegradable Chips Bag is Crunchier Than the Chips • As part of its product differentiation, the snack-food company Frito-Lay designed a biodegradable bag for its Sun Chips brand. • The bag also produces a loud crunching sound when squeezed. • Frito-Lay has incorporated the crunchiness of this bag into its marketing, as a way of distinguishing Sun Chips from competing products. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-18 Monopolistic Competition (cont'd) • Ease of entry – For any current monopolistic competitor, potential competition is always lurking in the background – The easier—that is, the less costly—entry is, the more a current competitor must worry about losing business Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-19 Price and Output for the Monopolistic Competitor • The individual firm’s demand and cost curves – Demand curve slopes downward – Profit maximized where MC intersects MR from below Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-20 Price and Output for the Monopolistic Competitor (cont'd) • Short-run equilibrium – In the short run, it is possible for a monopolistic competitor to make economic profits—profits over and above the normal rate of return, or beyond what is necessary to keep that firm in the industry – Losses in the short run are clearly also possible Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-21 Price and Output for the Monopolistic Competitor (cont'd) • The long run: zero economic profits – The rate of return will tend toward normal – Economic profits will tend toward zero • So many firms produce substitutes, any economic profits will disappear with competition • Reduced to zero either through entry of new firms seeking to earn a higher rate or return, or by changes in product quality and advertising outlays by existing firms Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-22 Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (a) Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-23 Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (b) Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-24 Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (c) Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-25 Comparing Perfect Competition with Monopolistic Competition • Question – If both a monopolistic and perfect competitor make zero economic profit in the long run, how are they different? • Answer – Demand curve for individual perfect competitor is perfectly elastic Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-26 Figure 25-2 Comparison of the Perfect Competitor with the Monopolistic Competitor Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-27 Comparing Perfect Competition with Monopolistic Competition (cont'd) • In perfect competition, the long-run equilibrium occurs where average total cost is minimized (this does not occur in monopolistic competition) • Some have argued that this is not necessarily a waste of resources—as the added cost arises from product differentiation • Chamberlin argued it is rational for consumers to have a taste for differentiation; consumers willingly accept the resultant increased production costs in return for more choice and variety of output Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-28 Brand Names and Advertising • Because “differentness” has value for consumers, monopolistically competitive firms regard their brand names as valuable private (intellectual) property – Firms use trademarks, words, symbols, and logos to distinguish their product brands from goods or services sold by other firms • A successful brand image contributes to a firm’s profitability Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-29 Brand Names and Advertising (cont'd) • Brand names and trademarks – A company’s value in the marketplace depends largely on current perceptions of future profitability – We can see it in the market value of the world’s most valuable product brands – Valuation depends on the market prices of shares of stock of a company times the number of shares traded Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-30 Table 25-1 Values of the Top Ten Brands Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-31 Methods of Advertising • Direct Marketing – Advertising targeted at specific consumers: email, regular mail • Mass Marketing – Advertising intended to reach as many customers as possible: radio, TV, newspaper • Interactive Marketing – Permits consumer to follow up directly by searching for more information Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-32 International Example: A Push to Make Electronic Billboards Interactive in Japan • In Japan, when a person glances at an electronic advertising display, the ad often looks back with a mechanism that can determine the age and gender of the person. • Based on the individual’s characteristics, the display will recommend a specific product tailored to individual needs. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-33 Figure 25-3 Distribution of U.S. Advertising Expenses Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-34 Informational Versus Persuasive Advertising • Search Good – A product with characteristics that enable an individual to evaluate the product’s quality in advance of a purchase • Experience Good – A product that an individual must consume before the product’s quality can be established • Credence Good – A product with qualities that consumers lack the expertise to assess without assistance Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-35 Brand Names and Advertising • Examples of search goods – Clothing and music evaluated prior to purchase • Examples of experience goods – Soft-drinks, restaurants, movies • Examples of credence goods – Health care, legal advice Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-36 Brand Names and Advertising (cont'd) • Informational Advertising – Advertising that emphasizes transmitting knowledge about the features of a product • Persuasive Advertising – Advertising that is intended to induce a consumer to purchase a particular product and discover a previously unknown taste for an item Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-37 Brand Names and Advertising (cont'd) • Advertising as a signaling behavior – Individual companies can explicitly engage in signaling behavior – They do so by establishing brand names or trademarks and promoting them Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-38 What If … the government were to limit or even ban “excessive” advertising? • Informational advertising is informative to buyers of search goods. • Even a firm’s expenditures on persuasive advertising communicate an intention to continue its operations for the foreseeable future. • Any attempt to restrict the amount of advertising would reduce the informational benefits to society. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-39 Information Products and Monopolistic Competition • Information products, such as computer operating systems, software, and digital music and videos, have a unique cost structure • Product development entails high fixed costs, but the marginal cost of producing a copy for one more customer is low Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-40 Information Products and Monopolistic Competition (cont'd) • Information Product – An item that is produced using informationintensive inputs at a relatively high fixed cost but distributed for sale at a relatively low marginal cost Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-41 Figure 25-4 Cost Curves for a Producer of an Information Product Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-42 Information Products and Monopolistic Competition (cont'd) • Short-Run Economies of Operation – A distinguishing characteristic of an information product arising from declining short-run average total cost as more units of the product are sold Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-43 Information Products and Monopolistic Competition (cont'd) • Consider how computer game manufacturers operate in a monopolistically competitive market. • In monopolistic competition, marginal cost pricing results in losses for the firm, even though it creates efficiencies for the economy as a whole. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-44 Information Products and Monopolistic Competition (cont'd) • Providing an information product entails incurring relatively high fixed costs, but a relatively low perunit cost for additional units of output • The ATC for a firm that sells an information product slopes downward, meaning the firm experiences short-run economies of operation • In a long-run monopolistically competitive equilibrium, price adjusts to equal ATC; the firm earns sufficient revenues to cover total costs, including the opportunity cost of capital • Consumers thereby pay the lowest price necessary to induce sellers to provide the item Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-45 Figure 25-5 The Infeasibility of Marginal Cost Pricing of an Information Product Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-46 You Are There: Have You Smelled a Ford Lately? • Linda Schmalz, a body interior materials engineer at Ford Motor Company, is responsible for determining the appropriate odors for accessories within the passenger compartment of Ford vehicles. • Schmalz has discovered that there are regional differences in people’s perception of odors. • This has prompted her to think about offering customized scents as a way of creating product differentiation for Ford vehicles. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-47 Issues & Applications: Why E-Books Are Upending the Publishing Business • Book publishing exhibits many features of monopolistic competition. • Given the relatively high fixed cost of authoring a book, publishers also face downward-sloping average total cost curves. • Variable costs are much lower for e-books, and this alternative has caused a decrease in demand for physical books. • The likely consequence is that some publishers of physical books will experience economic losses and may therefore exit the industry. Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-48 Summary Discussion of Learning Objectives • Key characteristics of a monopolistically competitive industry – Large number of small firms – Differentiated products – Easy entry and exit – Advertising and sales promotion Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-49 Summary Discussion of Learning Objectives (cont'd) • Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms – Monopolistically competitive firm in short run • Produces output to point MR = MC in short run • Price set on demand curve, can be less than MC and ATC in short run, firm earns economic profits Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-50 Summary Discussion of Learning Objectives (cont'd) • Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms – Monopolistically competitive firm in the long run • Price = ATC in the long run as firms enter industry • Like perfectly competitive firms, earns zero economic profits in long run • Price exceeds MC in long run Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-51 Summary Discussion of Learning Objectives (cont'd) • Monopolistically competitive firms attempt to boost demand for their products through product differentiation – They engage heavily in advertising and marketing • Providing an information product entails incurring relatively high fixed costs but low marginal costs – In the long run equilibrium, price adjusts to equality with average total cost Copyright ©2014 Pearson Education, Inc. All rights reserved. 25-52