Download Chapter 26

Chapter 25
Monopolistic
Competition
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Introduction
Why do so many rock bands today adopt names that
involve odd combinations of everyday words?
After all, what you care about is the quality of a band’s
songs, its style, and the musical talents of the band
members.
To find out the answer to this question, you must learn
about the market structure in which today’s rock bands
interact, known as monopolistic competition.
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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
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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
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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
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Did You Know That …
• By the time Dan Brown’s novel The Lost Symbol,
a sequel to The Da Vinci Code, appeared on
retailers’ shelves, its price had fallen so much that
retailers earned very few profits from selling the
book?
• Product heterogeneity and advertising did not
show up in our analysis of perfect competition.
• This instead is a situation of monopolistic
competition—the subject of this chapter.
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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
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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
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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
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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
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Monopolistic Competition (cont'd)
• Implications of the large number of firms
1. Small market share
2. Lack of collusion
3. Independence
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Monopolistic Competition (cont'd)
• Product Differentiation
– The distinguishing of products by brand name,
color, and other minor attributes.
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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
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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 weatherforecasting talents in an effort to attract tourists
to their communities.
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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?
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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
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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
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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
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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
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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
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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
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Figure 25-1 Short-Run and Long-Run Equilibrium
with Monopolistic Competition,
Panel (a)
• Price (P1) > ATC
• Economic profit
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Figure 25-1 Short-Run and Long-Run Equilibrium
with Monopolistic Competition,
Panel (b)
• Price (P1) < ATC
• Economic loss
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Figure 25-1 Short-Run and Long-Run Equilibrium
with Monopolistic Competition,
Panel (c)
• Price (P1) = ATC
• Normal rate of return
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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
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Figure 25-2 Comparison of the Perfect Competitor
with the Monopolistic Competitor
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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
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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
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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
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Table 25-1 Values of the Top Ten
Brands
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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
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Figure 25-3 Distribution of U.S.
Advertising Expenses
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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
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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
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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
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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
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Why Not … outlaw persuasive advertising?
• Because the purpose of persuasive advertising is
more to attract consumers’ attention and less to
provide product information, many people think
that persuasive advertising offers no clear
benefits to society at large.
• A company’s persuasive ads may demonstrate
that it intends to expand its customer base and
thereby perpetuates its operations for years to
come.
• In this way, even persuasive advertising offers
some information to consumers.
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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
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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
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Figure 25-4 Cost Curves for a Producer of an
Information Product
• TFC is $250,000
• Producer sells 5,000 copies
AFC falls to $50 per copy
• What is AFC if producer sells
50,000 copies?
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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
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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.
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Information Products and Monopolistic
Competition (cont'd)
• Providing an information product entails incurring
relatively high fixed costs, but a relatively low
per-unit 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
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Figure 25-5 The Infeasibility of Marginal Cost Pricing
of an Information Product
Firm cannot behave
as if it were a perfect
competitor setting
price at $2.50
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You Are There: Stimulating Candy Sales by
Adding Caffeine
• Vroom Foods differentiates its “energy candy”
products—Buzz Bites and Foosh Energy Mints—as
“the most caffeinated products out there.”
• Vroom’s competitors in the energy candy market
include Crackheads, Extreme Sport Beans, Ice
Breakers Energy Mints, and Snicker Charged
candy bars.
• In addition to including caffeine, Vroom is
increasingly seeking to differentiate its energy
candy products from the products of its
competitors.
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Issues & Applications: Finding a Band Name
Between ABBA and ZZ Top
• The industry or rock music is monopolistically
competitive as most bands seek to differentiate
themselves by writing their own novel songs, and
developing their own styles.
• Another key product characteristic is a band’s
name, as evidenced by names such as the
Beatles, Grateful Dead, Led Zeppelin, Metallica,
and Pink Floyd.
• Thus, one of the first agenda items for a band
after its formation is to find a unique name and
obtain a legal trademark for it.
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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
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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
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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
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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
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