Download 15.1 WHAT IS MONOPOLISTIC COMPETITION?

CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Describe and identify monopolistic competition.
2
Explain how a firm in monopolistic competition
determines its output and price in the short run and
the long run .
3
Explain why advertising costs are high and wy firms
use brand names in monopolistic competition.
15.1 WHAT IS MONOPOLISTIC COMPETITION?
Monopolistic competition is a market structure in
which:
• A large number of independent firms compete.
• Each firm produces a differentiated product.
• Firms compete on product quality, price, and
marketing.
• Firms are free to enter and exit.
15.1 WHAT IS MONOPOLISTIC COMPETITION?
Large Number of Firms
Like perfect competition, the market has a large number
of firms. Three implications are:
Small market share
No market dominance
Collusion impossible
15.1 WHAT IS MONOPOLISTIC COMPETITION?
Product Differentation
Product differentiation
Making a product that is slightly different from the
products of competing firms.
A differentiated product has close substitutes but it does
not have perfect substitutes.
When the price of one firm’s product rises, the quantity
demanded of that firm’s product decreases.
15.1 WHAT IS MONOPOLISTIC COMPETITION?
Competing on Quality, Price, and Marketing
Quality
Design, reliability, service, ease of access to the
product.
Price
A downward sloping demand curve.
Marketing
Advertising and packaging
15.1 WHAT IS MONOPOLISTIC COMPETITION?
 Entry and Exit
No barriers to entry.
A firm cannot make economic profit in the long run.
15.1 WHAT IS MONOPOLISTIC COMPETITION?
 Identifying Monopolistic Competition
Two indexes:
• The four-firm concentration ratio
• The Herfindahl-Hirschman Index
15.1 WHAT IS MONOPOLISTIC COMPETITION?
The four-firm concentration ratio
The percentage of the value of sales accounted for by
the four largest firms in the industry.
The range of concentration ratio is from almost zero for
perfect competition to 100 percent for monopoly.
• A ratio that exceeds 40 percent: indication of
oligopoly.
• A ratio of less than 40 percent: indication of
monopolistic competition.
15.1 WHAT IS MONOPOLISTIC COMPETITION?
The Herfindahl-Hirschman Index (HHI)
The square of the percentage market share of each firm
summed over the largest 50 firms in a market.
Example, four firms with market shares as 50 percent,
25 percent, 15 percent, and 10 percent.
HHI = 502 + 252 + 152 + 102 = 3,450
A market with an HHI less than 1,000 is regarded as
competitive.
An HHI between 1,000 and 1,800 is moderately
competitive.
15.1 WHAT IS MONOPOLISTIC COMPETITION?
Limitations of Concentration Measures
The two main limitations of concentration measures
alone as determinants of market structure are their
failure to take proper account of
• The geographical scope of a market
• Barriers to entry and firm turnover
15.2 OUTPUT AND PRICE DECISIONS
How, given its costs and the demand for its jeans, does
Tommy Hilfiger decide the quantity of jeans to produce
and the price at which to sell them?
The Firm’s Profit-Maximizing Decision
The firm in monopolistic competition makes its output
and price decision just like a monopoly firm does.
Figure 15.1 on the next slide illustrates this decision.
15.2 OUTPUT AND PRICE DECISIONS
1. Profit is maximized
when MR = MC
2. The profit-maximizing
output is 125 pairs of
Tommy jeans per day.
3. The profit-maximizing
price is $75 per pair.
ATC is $25 per pair, so
4. The firm makes an
economic profit of
$6,250 a day.
15.2 OUTPUT AND PRICE DECISIONS
Profit Maximizing Might Be Loss Minimizing
Some firms in monopolistic competition have a tough
time making a profit.
A burst of entry into an industry can limit the demand for
each firm’s own product.
Figure 15.2 on the next slide illustrates a firm incurring a
loss in the short run.
15.2 OUTPUT AND PRICE DECISIONS
1. Loss minimized when
MC = MR
2. The loss-minimizing
output is 40,000
customers.
3. The price is $40 per
month, which is less
than ATC.
4. The firm incurs an
economic loss.
15.2 OUTPUT AND PRICE DECISIONS
Long Run: Zero Economic Profit
Economic profit induces entry and economic loss
induces exit, as in perfect competition.
Entry decreases the demand for the product of each
firm.
Exit increases the demand for the product of each firm.
In the long run, economic profit is competed away and
firms earn normal profit.
Figure 15.3 on the next slide illustrates long-run
equilibrium.
15.2 OUTPUT AND PRICE DECISIONS
1. The output that
maximizes profit is 75
pairs of Tommy jeans a
day.
2. The price is $50 per
pair. Average total cost
is also $50 per pair.
3. Economic profit is
zero.
15.2 OUTPUT AND PRICE DECISIONS
Monopolistic Competition and Perfect
Competition
The two key differences between monopolistic
competition and perfect competition are that in
monopolistic competition, there is
• Excess capacity
• A markup of price over marginal cost
15.2 OUTPUT AND PRICE DECISIONS
Excess Capacity
A firm has excess capacity if the quantity it produces
is less that the quantity at which average total cost is a
minimum.
A firm’s efficient scale is the quantity of production at
which average total cost is a minimum.
Markup
A firm’s markup is the amount by which price exceeds
marginal cost.
15.2 OUTPUT AND PRICE DECISIONS
1. The efficient scale is 100
pairs of jeans a day.
2. The quantity produced is
less than the efficient scale
and the firm has excess
capacity.
3. Price exceeds marginal
cost by the amount of the
markup.
15.2 OUTPUT AND PRICE DECISIONS
In perfect competition, the
efficient quantity is produced
and price equals marginal
cost.
15.2 OUTPUT AND PRICE DECISIONS
Is Monopolistic Competition Efficient
Efficiency requires marginal benefit to equal marginal cost.
In monopolistic competition, price exceeds marginal cost,
which is an indicator of inefficiency.
Making the Relevant Comparison
Price exceeds marginal cost because of product
differentiation. But product variety is valued.
The Bottom Line
The bottom line is ambiguous. But compared to the
alternative, monopolistic competition looks efficient.
15.3 DEVELOPMENT AND MARKETING
 Innovation and Product Development
Wherever economic profits are earned, imitators
emerge.
To maintain economic profit, a firm must seek out new
products.
Cost Versus Benefit of Product Innovation
The firm must balance the cost and benefit at the
margin.
15.3 DEVELOPMENT AND MARKETING
Efficiency and Product Innovation
Regardless of whether a product improvement is real or
imagined, its value to the consumer is its marginal
benefit, which equals the amount the consumer is
willing to pay.
The marginal benefit to the producer is the marginal
revenue, which in equilibrium equals marginal cost.
Because price exceeds marginal cost, product
improvement is not pushed to its efficient level.
15.3 DEVELOPMENT AND MARKETING
Advertising
Firms in monopolistic competition spend a large amount
on advertising and packaging their products.
Marketing Expenditures
A large proportion of the prices that we pay cover the
cost of selling a good.
Figure 15.5 on the next slide shows some estimates of
marketing expenditures for some familiar markets.
15.3 DEVELOPMENT AND MARKETING
15.3 DEVELOPMENT AND MARKETING
Selling Costs and Total Costs
Advertising expenditures increase the costs of a
monopolistically competitive firm above those of a
perfectly competitive firm or a monopoly.
Advertising costs are fixed costs.
Advertising costs per unit decrease as production
increases.
Figure 15.6 on the next slide illustrates the effects of
selling costs on total cost.
15.3 DEVELOPMENT AND MARKETING
1. When advertising
costs are added to . . .
2. … the average total
cost of production,
…
3. … average total
cost increases by a
greater amount at
small outputs than
at large outputs.
15.3 DEVELOPMENT AND MARKETING
4. If advertising enables
sales to increase
from 25 pairs of jeans
a day to 100 pairs a
day, it lowers the
average total cost
from $60 a pair to
$40 a pair.
15.3 DEVELOPMENT AND MARKETING
Selling Costs and Demand
Advertising and other selling efforts change the demand
for a firm’s product.
The effects are complex:
• A firm’s own advertising increases the demand for
its product
• Advertising by all firms might decrease the
demand for any one firm’s product and make
demand more elastic.
The price and markup might fall.
15.3 DEVELOPMENT AND MARKETING
Figure 15.7 shows the
possible effect of
advertising.
With no advertising,
demand is low but the
markup is large.
15.3 DEVELOPMENT AND MARKETING
With advertising, average
total cost increases and the
ATC curve becomes ATC1.
Demand decreases and
becomes more elastic.
Profit maximizing output
increases, the price falls,
and the markup shrinks.
15.3 DEVELOPMENT AND MARKETING
Using Advertising to Signal Quality
Some advertising is very costly and has almost no
information content about the item being advertised.
Such advertising is used to signal high quality.
A signal is an action taken by an informed person or
firm to send a message to uninformed people.
Signaling works because it is profitable to signal high
quality and deliver it but unprofitable to signal a high
quality product and not deliver it.
15.3 DEVELOPMENT AND MARKETING
Brand Names
Brand names are also used to provide information
about the quality of a product.
It is costly to establish a widely recognized brand name.
Like costly advertising, a brand name signals high
quality.
Brand names work because it is unprofitable to incur
the cost of creating a brand name and then deliver a
low quality product.
15.3 DEVELOPMENT AND MARKETING
Efficiency of Advertising and Brand Names
Advertising and brand names that provide information
about the quality of products so that buyers are able to
make better choices can be efficient if the marginal cost
of the information equals its marginal benefit.
The final verdict on the efficiency of monopolistic
competition is ambiguous.