Chapter 16 in Economics and Microeconomics

Monopolistic Competition and Product Differentiation

Chapter Objectives: In this chapter, students will learn: - the meaning of monopolistic competition - why oligopolists and monopolistically competitive firms differentiate their products - how prices and output are determined in monopolistic competition in the short run (S-R) and in the long run (L-R) - why monopolistic competition poses a trade-off between lower prices and greater product diversity - the economic significance of advertising and brand names Chapter Outline Opening Ex: the fast-food industry is an example of a monopolistically competitive market, in which firms offer competing, differentiated products that are close but not perfect substitutes

A. 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, and -there is free entry into and exit from the industry in the long run -because there are many firms (each small compared to the market) - collusion is difficult (due to the large number of sellers) - actions of any one firm will be ignored by other firms (each firm is too small for its actions to be relevant to others) Product Differentiation - main characteristic distinguishing monopolistic competition from pure competition - plays a crucial role in monopolistic competition - it is the way firms can enjoy some market power -gives rise to non price competition (competition based upon features rather than price) -product differentiation may involve: - the product itself (physical characteristics) e.g., style, type or quality of product - conditions that accompany the sale (service, financing, return policies, warranties) - location (e.g., having a more extensive distribution network; having more desirable locations) - brand names and packaging (these may involve perceived product differences more than real differences) -for firm, the advantage of product differentiation is the chance to gain some control over the price of the product -ultimately, this increase in market power can lead to an increase in profits -product differential may be pursued via research and development (R&D) and thru advertising -for consumer, the advantage of product differentiation is more choice (differences in style, quality, etc.) and the possibility that efforts of manufacturers to differential their products lead to real product improvements B. Understanding Monopolistic Competition - monopolistic competition in the short run (S-R) - because there are many firms in monopolistic competition, firms cannot collude to increase their market power - monopolistic competitive firms face a downward sloping demand curve & marginal revenue (MR) curve - the demand curve for a firm under monopolistic competition would be: - less elastic than perfectly elastic (horiz.) curve firms under P.C. (as product differentiation affords some mkt. power) - more elastic than the demand curve of a monopolistic firm - in S-R, monopolistic competitive firms have: an upward-sloping marginal cost (MC) curve, and a U-shaped average total cost (ATC) curve - to maximize profits in the S-R, a monopolistic competitive firm should choose an output level were MR = MC - profitabity in the S-R lies in the relationship between the demand curve and the ATC curve - if ATC curve is below the demand curve at the MC=MR output level, then firm earns economic profit - if ATC curve is above the demand curve at the MC=MR output level, then firm is unprofitable see text Fig 16-1

firm can earn economic profit in the short-run

- output and price for a firm under monopolistic competition are determined in same way as a monopolistic firm i.e., from the point where MC = MR, project a line: - down to the horizontal axis to find the profit maximizing quantity of output, and - up to the demand curve & read the value of that point from the vertical axis to determine the profit maximizing price - monopolistic competition in the long run (L-R) - entry and exit affect the demand curve of every firm in the market - if firms earn economic profits, new firms will enter the market, shifting the demand curve for the existing firms to the left - if firms incur losses, firms exit the industry, shifting the demand curve for existing firms to the right - profit-maximizing quantity & loss-minimizing quantity - the market is in L-R equilibrium when there is no entry or exit - in the L-R, a monopolistically competitive industry ends up in zero-economic profit equilibrium: - in the L-R, each firm makes zero economic profit at its profit-maximizing (MC=MR) quantity see text Fig 16-3 - in the L-R, each firms ATC curve will be tangent to its demand curve at the profit-maximizing level of output

In long-run firms earn zero economic profit under Monopolistic Competition

C. Monopolistic Competition versus Perfect Competition Price (P), marginal cost (MC), and average total cost (ATC) - monopolistically competitive firms and perfectly competitive firms are similar in that in the L-R both receive a price that is equal to their ATC see text Fig 16-4

Comparing Long-Run Equilibrium in fect Competition (P.C.) and Monopolistic Competition - they differ in the following ways: 1-allocative efficiency - for a firm under P.C., price is equal to its MC. For a firm under monopolistic competition P > MC so, the firm under monopolistic competition wants to sell more than they currently sell (wants to sell until P = MC)

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2-production (tech) efficiency - for firm under P.C., price is equal to min. ATC. For monopolistic competitive firm P > min ATC firm produces less than the quantity that is needed to minimize ATC 3- firms under monopolistic competition face excess capacity => produce a quantity less than that needed to minimize ATC 4- is monopolistic competition inefficient? - some mutually beneficial trades go unrealized - the excess capacity leads to wasteful duplication => there are too many varieties of products - consumers, however, do benefit from the diversity of products in monopolistic competition

D. Controversies about Product Differentiation Non-price competition - based upon differentiated characteristics of product -can serve as a motivation for innovation (i.e., product improvements) Role of Advertising - advertising: - is only worthwhile in industries where firms have some market power - that provides product information has economic usefulness - influences consumers even when the ad provides little information - consumers may not be as rational as economists assert - ads can signal consumers about the availability and quality of a product - is advertising a waste of resources? - to the extent that advertising conveys important information, it is economically productive - if ads only work by manipulating the weak-minded, they are an economic waste - advertising can be used: - to highlight real product differences (helpful), or - to help create perceived differences (not so helpful) - advertising may help consumers: e.g., if advertising increases demand sufficiently, it could permit increased scale of production and a reduction in ATC (via economies of scale) which could allow the product to be sold for less - advertising may also add significant costs to price where it is unclear that consumer benefits from firms this spending e.g., 30% to 40% of the price of a typical box of breakfast cereal goes for advertising - band names - a brand name is a name owned by a particular firm that distinguishes its products from those of other firms - consumers often pay more for brand name products than identical and cheaper store brand items - brand names can convey information on product quality and reliability

What is the Goal? => more total profit - product differential makes it more difficult for rivals to effectively copy their distinguishing characteristics - some characteristics may be protected by patents, some are not readily copied (e.g., store locations) - differentiated products can also increase the cost of entering a market - these factors increase barriers to entry somewhat & make it more likely that firms can find strategies that allow economic profits to persist for a longer period of time than would be the case under perfect competition However: - while the graphic determination of price & quantity for monopolistic competition is similar to that of monopoly the market outcome (i.e., when economic profits occur) is more similar to perfect competition - since barriers to entry for monopolistic competition are less significant than for monopoly - in other words, firms can enter the market fairly easily => in response to the signal of economic profits and in doing so they increase the available supply & drive down the market price to the point where only normal profits are earned - firms under monopolistic competition, attempt to juggle three factors in efforts to maximize profit (typically by trial & error) 1- non-price competition based upon product differentiation (developing characteristics to make product stand out) 2- non-price competition based upon advertising (attempts to influence the demand curve for the product) 3- price based competition