C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to Describe and identify monopolistic competition.
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2 C H A P T E R C H E C K L I S TWhen you have completed your study of this chapter, you will be able toDescribe and identify monopolistic competition.1Explain how a firm in monopolistic competition determines its output and price in the short run and the long run .2Explain why advertising costs are high and wy firms use brand names in monopolistic competition.3
3 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.
4 15.1 WHAT IS MONOPOLISTIC COMPETITION? Large Number of FirmsLike perfect competition, the market has a large number of firms. Three implications are:Small market shareNo market dominanceCollusion impossible
5 15.1 WHAT IS MONOPOLISTIC COMPETITION? Product DifferentationProduct differentiationMaking 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 firm’s product rises, the quantity demanded of that firm’s product decreases.
6 15.1 WHAT IS MONOPOLISTIC COMPETITION? Competing on Quality, Price, and MarketingQualityDesign, reliability, service, ease of access to the product.PriceA downward sloping demand curve.MarketingAdvertising and packaging
7 15.1 WHAT IS MONOPOLISTIC COMPETITION? Entry and ExitNo barriers to entry.A firm cannot make economic profit in the long run.
8 15.1 WHAT IS MONOPOLISTIC COMPETITION? Identifying Monopolistic CompetitionTwo indexes:The four-firm concentration ratioThe Herfindahl-Hirschman Index
9 15.1 WHAT IS MONOPOLISTIC COMPETITION? The four-firm concentration ratioThe 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.
10 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 = = 3,450A market with an HHI less than 1,000 is regarded as competitive.An HHI between 1,000 and 1,800 is moderately competitive.
11 15.1 WHAT IS MONOPOLISTIC COMPETITION? Limitations of Concentration MeasuresThe two main limitations of concentration measures alone as determinants of market structure are their failure to take proper account ofThe geographical scope of a marketBarriers to entry and firm turnover
12 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 Firm’s Profit-Maximizing DecisionThe 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.
13 15.2 OUTPUT AND PRICE DECISIONS 1. Profit is maximized when MR = MC2. 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, so4. The firm makes an economic profit of $6,250 a day.
15 15.2 OUTPUT AND PRICE DECISIONS Profit Maximizing Might Be Loss MinimizingSome firms in monopolistic competition have a tough time making a profit.A burst of entry into an industry can limit the demand for each firm’s own product.Figure 15.1 on the next slide illustrates a firm incurring a loss in the short run.
16 15.2 OUTPUT AND PRICE DECISIONS 1. Loss minimized when MC = MR2. 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.
18 15.2 OUTPUT AND PRICE DECISIONS Long Run: Zero Economic ProfitEconomic 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.
19 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.
21 15.2 OUTPUT AND PRICE DECISIONS Monopolistic Competition and Perfect CompetitionThe two key differences between monopolistic competition and perfect competition are that in monopolistic competition, there isExcess capacityA markup of price over marginal cost
22 15.2 OUTPUT AND PRICE DECISIONS Excess CapacityA firm has excess capacity if the quantity it produces is less that the quantity at which average total cost is a minimum.A firm’s efficient scale is the quantity of production at which average total cost is a minimum.MarkupA firm’s markup is the amount by which price exceeds marginal cost.
23 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.
27 15.2 OUTPUT AND PRICE DECISIONS Is Monopolistic Competition EfficientEfficiency requires marginal benefit to equal marginal cost.In monopolistic competition, price exceeds marginal cost, which is an indicator of inefficiency.Making the Relevant ComparisonPrice exceeds marginal cost because of product differentiation. But product variety is valued.The Bottom LineThe bottom line is ambiguous. But compared to the alternative, monopolistic competition looks efficient.
28 15.3 DEVELOPMENT AND MARKETING Innovation and Product DevelopmentWherever economic profits are earned, imitators emerge.To maintain economic profit, a firm must seek out new products.Cost Versus Benefit of Product InnovationThe firm must balance the cost and benefit at the margin.
29 15.3 DEVELOPMENT AND MARKETING Efficiency and Product InnovationRegardless 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.
30 15.3 DEVELOPMENT AND MARKETING AdvertisingFirms in monopolistic competition spend a large amount on advertising and packaging their products.Marketing ExpendituresA 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.
33 15.3 DEVELOPMENT AND MARKETING Selling Costs and Total CostsAdvertising 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.
34 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.
38 15.3 DEVELOPMENT AND MARKETING Selling Costs and DemandAdvertising and other selling efforts change the demand for a firm’s product.The effects are complex:A firm’s own advertising increases the demand for its productAdvertising by all firms might decrease the demand for any one firm’s product and make demand more elastic.The price and markup might fall.
39 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.
41 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.
43 15.3 DEVELOPMENT AND MARKETING Using Advertising to Signal QualitySome 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.
44 15.3 DEVELOPMENT AND MARKETING Brand NamesBrand 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.
45 15.3 DEVELOPMENT AND MARKETING Efficiency of Advertising and Brand NamesAdvertising 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.