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© 2013 Pearson
Which cell phone?
© 2013 Pearson
17
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 why firms use
brand names in monopolistic competition.
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17.1 WHAT IS MONOPOLISTIC COMPETITION?
Monopolistic competition is a market structure in
which
• A large number of firms compete.
• Each firm produces a differentiated product.
• Firms compete on price, product quality, and
marketing.
• Firms are free to enter and exit.
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17.1 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
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17.1 WHAT IS MONOPOLISTIC COMPETITION?
Product Differentation
Product differentiation is 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.
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17.1 WHAT IS MONOPOLISTIC COMPETITION?
Competing on Quality, Price, and Marketing
Quality
Design, reliability, after-sales service, and buyer’s ease
of access to the product.
Price
Because of product differentiation, the demand curve
for the firms’ product is downward sloping.
Marketing
Marketing has two main forms: Advertising and
packaging.
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17.1 WHAT IS MONOPOLISTIC COMPETITION?
 Entry and Exit
No barriers to entry.
So the firm cannot make economic profit in the long run.
 Identifying Monopolistic Competition
Two indexes:
• The four-firm concentration ratio
• The Herfindahl-Hirschman Index
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17.1 WHAT IS MONOPOLISTIC COMPETITION?
The Four-Firm Concentration Ratio
The four-firm concentration ratio is 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 60 percent is an indication of
oligopoly.
• A ratio of less than 40 percent is an indication of a
competitive market—monopolistic competition.
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17.1 WHAT IS MONOPOLISTIC COMPETITION?
The Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is the
square of the percentage market share of each firm
summed over the largest 50 firms in a market.
For example, if four firms have market shares of 50
percent, 25 percent, 15 percent, and 10 percent, then
HHI = 502 + 252 + 152 + 102 = 3,450.
A market with an HHI of less than 1,000 is regarded as
competitive and between 1,000 and 1,800 is moderately
competitive.
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17.1 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
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17.2 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 17.1 on the next slide illustrates this decision.
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17.2 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.
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17.2 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 17.2 on the next slide illustrates a firm incurring a
loss in the short run.
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17.2 OUTPUT AND PRICE DECISIONS
1. Loss is minimized
when MC = MR.
2. The loss-minimizing
output is 40,000
customers and
3. The price is $40 per
month, which is less
than ATC.
4. The firm incurs an
economic loss.
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17.2 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 make zero economic profit.
Figure 17.3 on the next slide illustrates long-run
equilibrium.
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17.2 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.
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17.2 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
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17.2 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.
© 2013 Pearson
17.2 OUTPUT AND PRICE DECISIONS
1. The efficient scale is 100
pairs of Tommy jeans a
day.
2. The firm produces less
than the efficient scale and
has excess capacity.
3. Price exceeds 4. marginal
cost by the amount of
5. the markup.
6. Deadweight loss arise.
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17.2 OUTPUT AND PRICE DECISIONS
In perfect competition,
1. The efficient quantity is
produced and
2. Price equals marginal cost.
© 2013 Pearson
17.2 OUTPUT AND PRICE DECISIONS
Is Monopolistic Competition Efficient?
Deadweight Loss
Because price exceeds marginal cost, monopolistic
competition creates deadweight loss—an indicator of
inefficiency.
Making the Relevant Comparison
Price exceeds marginal cost because of product
differentiation. But product variety is valued.
The Bottom Line
Product variety is both valued and costly. But compared to
the alternative, monopolistic competition looks efficient.
© 2013 Pearson
17.3 PRODUCT DEVELOPMENT AND MARKETING
Product Development
Wherever economic profits are earned, imitators
emerge.
To maintain economic profit, a firm must seek out new
products.
Profit-Maximizing Product Development
When the marginal cost of a better product equals the
marginal revenue from a better product, the firm is
doing the profit-maximizing amount of product
development.
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17.3 PRODUCT DEVELOPMENT AND MARKETING
Efficiency and Product Development
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.
© 2013 Pearson
17.3 PRODUCT DEVELOPMENT AND MARKETING
Marketing
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.
Eye On Your Life shows the selling costs that you pay
when you buy a new pair of running shoes.
© 2013 Pearson
17.3 PRODUCT 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 17.5 on the next slide illustrates the effects of
selling costs on total cost.
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17.3 PRODUCT 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.
© 2013 Pearson
17.3 PRODUCT DEVELOPMENT AND MARKETING
4. If advertising
enables sales to
increase from 25
pairs of jeans a day
to 100 pairs a day,
the average total
cost falls from $60
a pair to $40 a pair.
© 2013 Pearson
17.3 PRODUCT 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 might make
demand more elastic.
The price and markup might fall.
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17.3 PRODUCT DEVELOPMENT AND MARKETING
Figure 17.6 shows the
possible effect of
advertising.
1. With no advertising,
demand is low but
2. The markup is large.
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17.3 PRODUCT DEVELOPMENT AND MARKETING
With advertising, average total cost increases.
If advertising enables more firms to survive, new firms
might be encouraged to enter the market.
The number of firms in the market might increase.
The demand for any one firm’s product decreases.
If all firms advertise, the demand for any one firm’s
product becomes more elastic.
© 2013 Pearson
17.3 PRODUCT DEVELOPMENT AND MARKETING
With advertising, average
total cost increases and the
ATC curve becomes ATC1.
If all firms advertise,
demand for one firm’s
product decreases and
becomes more elastic.
Profit-maximizing output
increases, the price falls,
and the markup shrinks.
© 2013 Pearson
17.3 PRODUCT 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.
© 2013 Pearson
17.3 PRODUCT 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.
© 2013 Pearson
17.3 PRODUCT DEVELOPMENT AND MARKETING
Efficiency of Advertising and Brand Names
Advertising and brand names that provide information
about the quality of products enable buyers to make
better choices.
Advertising and brand name 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.
© 2013 Pearson
Which Cell Phone?
There is a lot of product differentiation in cell phones:
Nokia makes 143; versions; Samsung makes 103; and
Sony Ericsson makes 100.
In the three months from April through June 2011,
hundreds of new varieties of cell phones were
announced by the top 20 firms in this market.
Why is there so much variety in cell phones?
The answer is that preferences are diverse and the cost
of matching the diversity of preference is low.
© 2013 Pearson
Which Cell Phone?
Think about the ways in which cell phones differ.
Just a few of them are its dimensions, weight, navigation
tools, talk time, standby time, screen, camera features,
audio features, memory, connectivity, processor speed,
storage, and network capability.
Each one of these features comes in dozens of varieties.
How many possible designs?
For example, if a phone had 10 features and each
feature comes in 6 varieties, there are 1 million different
possible designs.
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Which Cell Phone?
Firms produce variety only when the marginal cost of
doing so is less than the marginal benefit.
The marginal cost of some cell-phone variety is not large.
But a new way of adding variety that has almost no cost
will bring product differentiation that makes each cell
phone unique to the preferences of each individual.
This new way is the cell-phone application.
Apple has only two versions of the iPhone, but each
iPhone owner can load their phone with exactly the
program applications they want.
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Which Cell Phone?
In the long run, entry and innovation by each producer
will drive the economic profit toward zero.
The pursuit of economic profit will spur ever more
innovation.
Consumers will be confronted with ever wider choice.
© 2013 Pearson