chapter 12a/25 microeconomics

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Monopolistic Competition

Prof. Charles Fusi

Chapter 12A/25 Microeconomics

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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.

Lecture by Prof. Charles Fusi

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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 CompetitionPrice and Output for the Monopolistic

CompetitorComparing Perfect Competition with

Monopolistic Competition Brand Names and AdvertisingInformation Products and Monopolistic

Competition


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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

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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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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Implications of the large number of firms

1. Small market share

2. Lack of collusion

3. Independence


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Product Differentiation

The distinguishing of products by brand name, color, and other minor attributes.


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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 productsThe 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 weather-forecasting talents in an effort to attract tourists to their communities.


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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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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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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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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 zeroSo 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 12A/25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (a)

• Price (P1) > ATC• Economic profit


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Figure 12A/25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (b)

•Price (P1) < ATC•Economic loss


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Figure 12A/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

QuestionIf both a monopolistic and perfect

competitor make zero economic profit in the long run, how are they different?

AnswerDemand curve for individual perfect

competitor is perfectly elastic


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Figure 12A/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 firmsA 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 12A/25-1 Values of the Top Ten Brands


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Methods of Advertising

Direct MarketingAdvertising targeted at specific

consumers: e-mail, regular mail

Mass MarketingAdvertising intended to reach as many

customers as possible: radio, TV, newspaper

Interactive MarketingPermits consumer to follow up directly by

searching for more informationLecture by Prof. Charles Fusi

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Figure 12A/25-3 Distribution of U.S. Advertising Expenses


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Informational Versus Persuasive Advertising

Search GoodA product with characteristics that

enable an individual to evaluate the product’s quality in advance of a purchase

Experience GoodA product that an individual must

consume before the product’s quality can be established

Credence GoodA 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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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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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 information-intensive inputs at a relatively high fixed cost but distributed for sale at a relatively low marginal cost


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Figure 12A/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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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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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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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 12A/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 NameBetween 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 runProduces output to point MR = MC in short

runPrice set on demand curve, can be less than

MC and ATC in short run, firm earns economic profits


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Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms

Monopolistically competitive firm in the long runPrice = ATC in the long run as firms enter

industryLike perfectly competitive firms, earns zero

economic profits in long runPrice exceeds MC in long run


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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


chapter 12a/25 microeconomics

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