1. Chapter 26 Monopolistic Competition

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-2 Introduction The typical consumers of “toy trains” are not children. In order to appeal to the adult consumers, producers differentiate their trains by making them look realistic. Recently, real-world rail transport companies have pushed up the cost of product differentiation. Producers pay license fees to real-world transport companies to use their logos, which affect prices and output in a monopolistically competitive market.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-3 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

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-4 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

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-5 Chapter Outline Monopolistic Competition Price and Output for the Monopolistic Competitor Price and Output for the Monopolistic Competitor Comparing Perfect Competition with Monopolistic Competition Comparing Perfect Competition with Monopolistic Competition Brand Names and Advertising Information Products and Monopolistic Competition Information Products and Monopolistic Competition

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-6 Did You Know That… Since 2004, annual spending on new building construction at U.S. colleges and universities has exceeded $14 billion per year? Most of the expenditures have financed student centers with various amenities that individual universities hope will help their schools stand out?

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-7 Did You Know That… (cont'd) Advertising plays a large role in industries that cannot be described as perfectly competitive but cannot be described as pure monopolies either? Consumers’ preferences for variety and competition among producers has led to similar but differentiated products in the marketplace. This situation has been described as monopolistic competition.

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-8 Monopolistic Competition In the 1920s and 1930s, economists were aware of industries that did not fit under perfect competition or pure monopoly. Theoretical and empirical research was instituted to develop some sort of middle ground.

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-9 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.

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-10 Monopolistic Competition (cont'd) 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.

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-11 Monopolistic Competition (cont'd) Characteristics of monopolistic competition 1. Significant number 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

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-12 Monopolistic Competition (cont'd) Implications of the large number of firms 1. Small market share 2. Lack of collusion 3. Independence

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-13 Monopolistic Competition (cont'd) Product Differentiation  The distinguishing of products by brand name, color, and other minor attributes

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-14 Monopolistic Competition (cont'd) Product differentiation and price  Firm has some control over the price it charges.  Unlike perfect competitor, it faces a downward sloping demand curve.  Consider the abundance of brand names for many products.  The more successful the firm is at differentiation, the more control it has over price.

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-15 Example: What Else Besides a Tart Taste do Cranberries Have to Offer? Making cranberries taste like other fruits and berries presented cranberry producers the problem of how to differentiate their product. Producers have promoted taste and the healthful properties of cranberry juice. Sellers emphasize the distinctive experience associated with eating the fruit and its curative properties.

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-16 Monopolistic Competition (cont'd) What do you think?  Would a perfect competitor have any incentive to advertise?  Why would a monopolistically competitive firm advertise?  Can advertising lead to efficiency?

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-17 Monopolistic Competition (cont'd) Sales promotion and advertising  Can increase demand for a firm  Can differentiate a firm’s product  Can result in increased profits

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-18 Monopolistic Competition (cont'd) 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.

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-19 Monopolistic Competition (cont'd) 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.

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-20 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

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-21 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.

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-22 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 zero.  So 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

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-23 Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (a) Price (P 1 ) > ATC Economic profit

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-24 Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (b) Price (P 1 ) < ATC Economic loss

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-25 Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (c) Price (P 1 ) = ATC Normal rate of return

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-26 Comparing Perfect Competition with Monopolistic Competition Question  If both a monopolistic and perfect competitor make zero economic profit in the long run, how are they different? Answer  Demand curve for individual perfect competitor is perfectly elastic.

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-27 Figure 26-2 Comparison of the Perfect Competitor with the Monopolistic Competitor

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-28 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.

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-29 Brand Names and Advertising Because “differentness” has value for consumers, monopolistically competitive firms regard their brand names as valuable private (intellectual) property.  Use trademarks, words, symbols, and logos to distinguish their product brands from goods or services sold by other firms  A successful brand image contributes to a firm’s profitability.

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-30 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.

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-31 Table 26-1 Values of the Top Ten Brands

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-32 Methods of Advertising Direct Marketing  Advertising targeted at specific consumers: e-mail, regular mail Mass Marketing  Advertising intended to reach as many customers as possible: radio, TV, newspaper Interactive Marketing  Permits consumer to follow up directly by searching for more information

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-33 Figure 26-3 Distribution of U.S. Advertising Expenses

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-34 Informational Versus Persuasive Advertising Search Good  A product with characteristics that enable an individual to evaluate the product’s quality in advance of a purchase Experience Good  A product that an individual must consume before the product’s quality can be established Credence Good  A product with qualities that consumers lack the expertise to assess without assistance

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-35 Brand Names and Advertising Search goods  Clothing and music evaluated prior to purchase Experience goods  Soft-drinks, restaurants, movies Credence goods  Health care, legal advice

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-36 Brand Names and Advertising (cont'd) 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

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-37 Brand Names and Advertising (cont'd) 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.

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-38 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.

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-39 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

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-40 Figure 26-4 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?

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-41 Information Products and Monopolistic Competition (cont'd) 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

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-42 Information Products and Monopolistic Competition (cont'd) 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.

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-43 Figure 26-5 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

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-44 Information Products and Monopolistic Competition (cont'd) 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 equality with ATC; the firm earns sufficient revenues to cover total costs, including the opportunity cost of capital.

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-45 Issues and Applications: Paying for the Right to Produce Realistic Model Trains A toy hobby meets trademark protection. In model railroading, product differentiation now has a price. Why might those old trademarks be worth something?

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-46 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

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-47 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 run  Produces output to point MR = MC in short run  Price set on demand curve, can be less than MC and ATC in short run, firm earns economic profits

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-48 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 the long run  Price = ATC in the long run as firms enter industry  Like perfectly competitive firms, earns zero economic profits in long run  Price exceeds MC in long run

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-49 Summary Discussion of Learning Objectives (cont'd) Monopolistically competitive firms attempt to boost demand for their products through product differentiation. Providing an information product entails incurring relatively high fixed costs but low marginal costs.

50. End of Chapter 26 Monopolistic Competition