CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to

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Describe and identify monopolistic competition. Explain how a firm in monopolistic competition determines its output and price in the short run and the long run . 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 firms product rises, the quantity demanded of that firms 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 Firms 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 firms own product.
Figure 15.1 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 firms efficient scale is the quantity of production at which average total cost is a minimum. Markup

A firms 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 firms product. The effects are complex: A firms own advertising increases the demand for its product Advertising by all firms might decrease the demand for any one firms 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.