2Objectives After studying this chapter, you will be able to: Define and identify monopolistic competitionExplain how price and output are determined in a monopolistically competitive industryExplain why advertising and branding costs are high in a monopolistic competitionDefine and identify oligopolyExplain two traditional models of oligopolyUnderstanding real world marketsStudents have no difficulty seeing monopolistic competition in the world all around them.Emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of monopolistic competition, as its name implies, is a mixture of both extremes.Some of what they learned in each of the two previous chapters survives and operates in the middle ground of monopolistic competition.
3Fliers, Coupons, and Specials Supermarkets like Coles and Woolworth and department stores like K-Mart and Target advertise each week’s specials to tell us that they have the best product at the best price.Firms in these markets are neither price takers like those in perfect competition, nor are they protected from competition by barriers to entry like a monopoly.How do such firms choose the quantity to produce and price?
4What is Monopolistic Competition? Monopolistic competition is a market with the following characteristics:A large number of firms.Each firm produces a differentiated product.Firms compete on product quality, price, marketing and branding.Firms are free to enter and exit.
5Monopolistic Competition Large Number of FirmsThe presence of a large number of firms has three implications:Small market shareCan ignore other firmsCollusion is impossible
6Monopolistic Competition Product DifferentiationFirms in monopolistic competition practice product differentiation, which means that each firm makes a product that is slightly different from the products of competing firms.Product differentiation—the heart of the space between monopoly and competition An old ice-cream on the beach analogy really nails down the idea of product differentiation and explains how monopolistic competition fills the space between monopoly and perfect competition. Draw a line on the blackboard and label the two ends A and B. Tell the students that the line represents a beach (a long beach) along which beachgoers are uniformly spaced. An ice-cream vendor decides to set up shop on the beach—the only one. Where will she locate? The students will quickly see that the center—midway between A and B is the spot that will get the most customers because the cost of an ice cream is the market price plus the walking time to get it (remind them that the beach is very long!) Now a second ice-cream vendor opens up. Where does he locate? With a bit of help, the students will see that the best spot is right next to the first one. With one producer, there is monopoly and no variety—no product differentiation. With two producers, there is still no differentiation—technically, there is minimum differentiation. Now suppose a third and fourth ice-cream vendor come along. Where to they locate? At the ends of the beach at A and B. They differentiate as much as possible from each other and from the first two. Further entry has new ice-cream vendors locating in the middle of the gaps between the existing ones, always going into the widest gap. If the market could stand the competition, eventually, there would be ice-cream vendors so close to each other all along the beach that the members of any adjacent group were indistinguishable to a customer. Product differentiation would have been pushed to the point that there is no “space” for additional variety and the market would look like perfect competition.Real products are like the beach example Talk about sports shoes, breakfast cereals, and any other goods that interest you and for which there are good locally observable examples and encourage the students to see that they are like the beach example. The variety of products fill the available variety “space.”
7What is Monopolistic Competition? Competing on Quality, Price, Marketing and BrandingProduct differentiation enables firms to compete in four areas:Quality.PriceEach firm has a downward-sloping demand curve for its own product.Marketing through advertising and packagingBranding through name, sign or symbol
8What is Monopolistic Competition? Entry and ExitThere are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run.Identifying Monopolistic CompetitionAll four features of monopolistic competition must be present.Examples of Monopolistic CompetitionAudio and video equipment, computers, frozen foods, petrol stations.
9What is Monopolistic Competition? Imperfect competition, not monopolistic competitionWhen a brand becomes a dominant, the brand itself becomes a barrier to entry, as entry of new firms may not drive down its priceBrand names that are incredibly successful include, Coco-Cola, Heinz, and Kellogg’s
10Price and Output in Monopolistic Competition Short-Run Output and Price DecisionProduces the profit maximising quantity at which its marginal revenue equals its marginal cost (MR = MC).Price is determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profit-maximising quantity.
11Economic Profit in the Short Run Figure 12.1MC125Price greaterThan averageTotal costATC100DMR75EconomicprofitPrice & cost (dollars per FrenchConnection jacket)5025Profit maximisingquantity50100125150200250Quantity (French Connection jackets per day)
12Price and Output in Monopolistic Competition Profit Maximising Might be Loss MinimisingA firm might face a level of demand for its product that is too low for it to make an economic profit.A firm could maximise profit or minimise loss by producing the output at which marginal revenue equals marginal cost
13Economic Profit in the Short Run ATCFigure 12.3MCPrice lessthan averagetotal cost8060DMR50Economicloss40Price & cost (dollars per FrenchConnection jacket)Marginal revenue= marginal cost20Profit maximising(loss-minimising quantity20406080100Quantity (French Connection jackets per day)
14Price and Output in Monopolistic Competition Long Run: Zero Economic ProfitIn the long run, economic profit induces entry. If firms incur economic losses, exit will occur.Entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC).Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit.If firms were incurring economic losses, exit of firms will occur until all firms earn zero economic profit
15Output and Price in the Long Run MCOutput and Price in the Long RunATCFigure 12.3Marginal revenue= marginal cost8060MRD50Price = averagetotal cost40Price & cost (dollars per FrenchConnection jacket)20Profit maximisingquantity5075100150Quantity (French Connection jackets per day)
16Price and Output in Monopolistic Competition Monopolistic Competition and Perfect CompetitionTwo key differences:Excess CapacityA firm has excess capacity if it produces below its efficient scale.MarkupMarkup is the amount by which price exceeds marginal cost
17Excess Capacity and Markup MCExcess Capacity and MarkupATCFigure 12.4(a)50PriceMonopolisticCompetition40MRD3025MarkupEfficientscale20Price & cost (dollars per FrenchConnection jacket)10Marginal costExcesscapacity5075100150Quantity (French Connection jackets per day)
18Excess Capacity and Markup Figure 12.4(b)ATCMC40PerfectCompetitionPrice =Marginal cost30Price and costs (dollars per jacket)23Quantity =efficient scaleAR = MR105075100125150Quantity (jackets per day)66
19Price and Output in Monopolistic Competition Is Monopolistic Competition Efficient?Firms charge price in excess of marginal cost.Therefore, the market structure is inefficient.However, consumers gain variety.The loss in efficiency must be weighed against the gain of greater product variety.
20Product Development and Marketing Innovation and Product DevelopmentTo keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development.New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation.
21Product Development and Marketing Costs versus Benefit of Product InnovationInnovation is costly, but it increases total revenue.Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation.Production development may benefit the consumer by providing an improved product.
22Product Development and Marketing AdvertisingAdvertising and packaging are the two principal methods firms in monopolistic competition use to differentiate their productsFirms in monopolistic competition incur heavy marketing and advertising expenditures to enhance the perception of quality differences between their product and rival products..
24Product Development and Marketing Selling Costs and Total CostsSelling costs, like advertising expenditures, are fixed costs.Advertising costs per unit decrease as production decreases.
25Product Development and Marketing Selling Costs and DemandAdvertising can increase a firm’s demand and profits.Advertising and selling costs provide consumers with information and services that they value more highly than their cost. These activities are therefore efficient.
26Advertising and the Markup Figure 12.7(a).. Markupis largeWith no advertisingDemand is low but . . .ATCMC100No FirmsAdvertise80DMR60Price & cost (dollars per FrenchConnection jacket)5550255075100125150200250Quantity (French Connection jackets per day)
27Product Development and Marketing Using Advertising to Signal QualityExpansive advertising signals a high quality productA signal is an action taken by an informed person (or a firm) to send a message to uninformed personBrand namesA brand name provides information about the quality of a product to consumersEfficiency of advertising and brand names
28What is Oligopoly? Oligopoly is a market structure in which: Natural or legal barriers prevent the entry of new firmsA small number of firms competeUnderstanding real world markets. Students have no difficulty seeing oligopoly in the world around them. Again, emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of oligopoly can be better understood by building on some of the features of competition and monopoly. Again, some of what they learned in each of the two previous chapters survives and operates in oligopoly.Traditional oligopoly models. Many instructors today want to skip the traditional models of oligopoly. Others want to teach only these models and skip the game theory approach. Your choice! This chapter is written in self-contained sections so that you can skip either approach.
29What is Oligopoly? Barriers to Entry Either natural or legal barriers to entry can create oligopolyEconomies of scale and demand can form a natural barriers to entry and create oligopolyA legal oligopoly arises when a legal barrier to entry protects the small number of firms in a market
30Natural Oligopoly Natural Duopoly Natural oligopoly with three firms Figure 12.8252015105252015105Natural DuopolyNatural oligopoly withthree firmsATC1ATC2Price and cost (dollars per ride)Price and cost (dollars per ride)Lowest possibleprice = Min ATCDDEfficient scaleof one firmThree firmscan meetdemandEfficient scaleof one firmTwo firms canmeet demandQuantity (rides per day)Quantity (rides per day)116
31What is Oligopoly? Small Number of Firms Examples of Oligopoly Oligopoly consists of a small number of firms each of which has a large share of the market.Such firms are interdependent and they face a temptation to cooperate to increase their joint profit.Examples of OligopolyIdentify oligopoly by looking at the concentration ratios. A four-firm concentration ratio where share of total revenue exceeds 60 percent indicates oligopoly.
32Two Traditional Oligopoly Models The Kinked Demand Curve ModelThe kinked demand curve model of oligopoly is based on the assumption that each firm believes that if it raises its price, others will not follow, but if it cuts its price, other firms will cut theirs.
33Two Traditional Oligopoly Models Dominant Firm OligopolyIn a dominant firm oligopoly, there is one large firm—the dominant firm—that has a significant cost advantage over many other, smaller competing firms.The dominant firm sets the market price and the other firms are price takersExamples: large petrol retailer, a big video rental store in a local market
34A Dominant Firm Oligopoly Figure 12.10Ten small firms and market demandBig-G’s price and output decisionS10MC1.501.50MRPrice (dollars per litre)ABA1.0010B1.00D0.500.50XD102020Quantity (thous. of litres/week)Quantity (thous. of litres/week)43