Imperfect Competition Chapter 12: Imperfect Competition

Objectives After studying this chapter, you will be able to: Define and identify monopolistic competition Explain how price and output are determined in a monopolistically competitive industry Explain why advertising and branding costs are high in a monopolistic competition Define and identify oligopoly Explain two traditional models of oligopoly Understanding real world markets Students 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.

Fliers, 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?

What 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.

Monopolistic Competition Large Number of Firms The presence of a large number of firms has three implications: Small market share Can ignore other firms Collusion is impossible

Monopolistic Competition Product Differentiation Firms 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.”

What is Monopolistic Competition? Competing on Quality, Price, Marketing and Branding Product differentiation enables firms to compete in four areas: Quality. Price Each firm has a downward-sloping demand curve for its own product. Marketing through advertising and packaging Branding through name, sign or symbol

What is Monopolistic Competition? Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. Identifying Monopolistic Competition All four features of monopolistic competition must be present. Examples of Monopolistic Competition Audio and video equipment, computers, frozen foods, petrol stations.

What is Monopolistic Competition? Imperfect competition, not monopolistic competition When a brand becomes a dominant, the brand itself becomes a barrier to entry, as entry of new firms may not drive down its price Brand names that are incredibly successful include, Coco-Cola, Heinz, and Kellogg’s

Price and Output in Monopolistic Competition Short-Run Output and Price Decision Produces 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.

Economic Profit in the Short Run Figure 12.1 MC 125 Price greater Than average Total cost ATC 100 D MR 75 Economic profit Price & cost (dollars per French Connection jacket) 50 25 Profit maximising quantity 50 100 125 150 200 250 Quantity (French Connection jackets per day)

Price and Output in Monopolistic Competition Profit Maximising Might be Loss Minimising A 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

Economic Profit in the Short Run ATC Figure 12.3 MC Price less than average total cost 80 60 D MR 50 Economic loss 40 Price & cost (dollars per French Connection jacket) Marginal revenue = marginal cost 20 Profit maximising (loss-minimising quantity 20 40 60 80 100 Quantity (French Connection jackets per day)

Price and Output in Monopolistic Competition Long Run: Zero Economic Profit In 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

Output and Price in the Long Run MC Output and Price in the Long Run ATC Figure 12.3 Marginal revenue = marginal cost 80 60 MR D 50 Price = average total cost 40 Price & cost (dollars per French Connection jacket) 20 Profit maximising quantity 50 75 100 150 Quantity (French Connection jackets per day)

Price and Output in Monopolistic Competition Monopolistic Competition and Perfect Competition Two key differences: Excess Capacity A firm has excess capacity if it produces below its efficient scale. Markup Markup is the amount by which price exceeds marginal cost

Excess Capacity and Markup MC Excess Capacity and Markup ATC Figure 12.4(a) 50 Price Monopolistic Competition 40 MR D 30 25 Markup Efficient scale 20 Price & cost (dollars per French Connection jacket) 10 Marginal cost Excess capacity 50 75 100 150 Quantity (French Connection jackets per day)

Excess Capacity and Markup Figure 12.4(b) ATC MC 40 Perfect Competition Price = Marginal cost 30 Price and costs (dollars per jacket) 23 Quantity = efficient scale AR = MR 10 50 75 100 125 150 Quantity (jackets per day) 66

Price 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.

Product Development and Marketing Innovation and Product Development To 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.

Product Development and Marketing Costs versus Benefit of Product Innovation Innovation 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.

Product Development and Marketing Advertising Advertising and packaging are the two principal methods firms in monopolistic competition use to differentiate their products Firms in monopolistic competition incur heavy marketing and advertising expenditures to enhance the perception of quality differences between their product and rival products..

Advertising Expenditure

Product Development and Marketing Selling Costs and Total Costs Selling costs, like advertising expenditures, are fixed costs. Advertising costs per unit decrease as production decreases.

Product Development and Marketing Selling Costs and Demand Advertising 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.

Advertising and the Markup Figure 12.7(a) .. Markup is large With no advertising Demand is low but . . . ATC MC 100 No Firms Advertise 80 D MR 60 Price & cost (dollars per French Connection jacket) 55 50 25 50 75 100 125 150 200 250 Quantity (French Connection jackets per day)

Product Development and Marketing Using Advertising to Signal Quality Expansive advertising signals a high quality product A signal is an action taken by an informed person (or a firm) to send a message to uninformed person Brand names A brand name provides information about the quality of a product to consumers Efficiency of advertising and brand names

What is Oligopoly? Oligopoly is a market structure in which: Natural or legal barriers prevent the entry of new firms A small number of firms compete Understanding 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.

What is Oligopoly? Barriers to Entry Either natural or legal barriers to entry can create oligopoly Economies of scale and demand can form a natural barriers to entry and create oligopoly A legal oligopoly arises when a legal barrier to entry protects the small number of firms in a market

Natural Oligopoly Natural Duopoly Natural oligopoly with three firms Figure 12.8 25 20 15 10 5 25 20 15 10 5 Natural Duopoly Natural oligopoly with three firms ATC1 ATC2 Price and cost (dollars per ride) Price and cost (dollars per ride) Lowest possible price = Min ATC D D Efficient scale of one firm Three firms can meet demand Efficient scale of one firm Two firms can meet demand 30 60 90 20 40 60 Quantity (rides per day) Quantity (rides per day) 116

What 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 Oligopoly Identify oligopoly by looking at the concentration ratios. A four-firm concentration ratio where share of total revenue exceeds 60 percent indicates oligopoly.

Two Traditional Oligopoly Models The Kinked Demand Curve Model The 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.

Two Traditional Oligopoly Models Dominant Firm Oligopoly In 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 takers Examples: large petrol retailer, a big video rental store in a local market

A Dominant Firm Oligopoly Figure 12.10 Ten small firms and market demand Big-G’s price and output decision S10 MC 1.50 1.50 MR Price (dollars per litre) A B A 1.00 10 B 1.00 D 0.50 0.50 XD 10 20 20 Quantity (thous. of litres/week) Quantity (thous. of litres/week) 43

END CHAPTER 12