Download Monopolistic Competition in the Long Run

CHAPTER 16
Monopolistic Competition and
Product Differentiation
PowerPoint® Slides
by Can Erbil and Gustavo Indart
© 2005 Worth Publishers
© 2005 Worth Publishers, all rights
reserved
Slide 16-1
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

© 2005 Worth Publishers
Slide 16-2
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
 there is free entry into and exit from the
industry in the long run
© 2005 Worth Publishers
Slide 16-3
Product Differentiation
Product differentiation plays an even more crucial role
in monopolistically competitive industries. Why?


Tacit collusion is virtually impossible when there are
many producers. Hence, product differentiation is the
only way monopolistically competitive firms can acquire
some market power.
Then, how do firms in the same industry—such as fastfood vendors, gas stations, or chocolate companies—
differentiate their products?

Is the difference mainly in the minds of consumers or
in the products themselves?

© 2005 Worth Publishers
Slide 16-4
Product Differentiation
There are three important forms of product
differentiation:
 Differentiation by style or type – Sedans vs.
SUV’s
 Differentiation by location – Dry cleaner
near home vs. cheaper dry cleaner far away
 Differentiation by quality – Ordinary ($) vs.
gourmet chocolate ($$$)
© 2005 Worth Publishers
Slide 16-5
Product Differentiation
Whatever form it takes, however, there are two
important features of industries with differentiated
products:
 Competition among sellers: Producers compete for
the same market, so entry by more producers
reduces the quantity each existing producer sells at
any given price
 Value in diversity: In addition, consumers gain
from the increased diversity of products
© 2005 Worth Publishers
Slide 16-6
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!

© 2005 Worth Publishers
Slide 16-7
Understanding Monopolistic Competition
As the term monopolistic competition suggests, this
market structure combines some features typical
of monopoly with others typical of perfect
competition:
 Because each firm is offering a distinct product, it
is in a way like a monopolist: it faces a downwardsloping demand curve and has some market
power—the ability within limits to determine the
price of its product
 However, unlike a pure monopolist, a
monopolistically competitive firm does face
competition: the amount of its product it can sell
depends on the prices and products offered by
other firms in the industry
© 2005 Worth Publishers
Slide 16-8
Understanding Monopolistic
Competition: The Monopolistically
Competitive Firm in the Short Run
The following figure shows two possible situations that a
typical firm in a monopolistically competitive industry
might face in the short run.
 In each case, the firm looks like any monopolist: it
faces a downward-sloping demand curve, which
implies a downward-sloping marginal revenue curve
 We assume that every firm has an upward-sloping
marginal cost curve, but that it also faces some fixed
costs, so that its average total cost curve is U-shaped
© 2005 Worth Publishers
Slide 16-9
Short-Run Equilibrium
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 profitmaximizing 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.
© 2005 Worth Publishers
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 results in a greater loss.
Slide 16-10
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
© 2005 Worth Publishers
Slide 16-11
Entry and Exit into the Industry Shifts 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.
© 2005 Worth Publishers
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 rises.
Exit will cease when the remaining firms
make zero profit.
Slide 16-12
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 profit-maximizing output level: at the profit-maximizing output
level, QMC, price, PMC, equals average total cost, ATCMC.
© 2005 Worth Publishers
Slide 16-13
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

© 2005 Worth Publishers
Slide 16-14
Long-Run Equilibrium
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 .
© 2005 Worth Publishers
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 capacity.
Slide 16-15
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

© 2005 Worth Publishers
Slide 16-16
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
© 2005 Worth Publishers
Slide 16-17
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

© 2005 Worth Publishers
Slide 16-18
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

© 2005 Worth Publishers
Slide 16-19
The End of Chapter 16
Coming Attraction:
Chapter 17:
International Trade
© 2005 Worth Publishers
Slide 16-20