Objectives © Pearson Education, 2005 Monopolistic Competition LUBS1940: Topic 6

Objectives © Pearson Education, 2005 After studying this topic, you will able to:  Define and identify monopolistic competition  Explain how output and price are determined in a monopolistically competitive industry  Explain why advertising and branding costs are high in a monopolistic competition

© Pearson Education, 2005 Fliers and Brand Names Every week, newspapers across Europe are stuffed with supermarket fliers. How do supermarkets compete? How do brand names change the competitive landscape? These firms 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 to charge?

© Pearson Education, 2005 What is Monopolistic Competition? Monopolistic competition is a market structure in which: (1) Large Number of Firms The presence of a large number of firms has three implications: Small Market Share Each firm supplies only a small market share part of the total market and so has limited market power to influence the price of its product. Ignore Other Firms Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other and so no one firm’s actions directly affect the actions of other firms. Collusion Impossible Because there are so many firms, collusion to fix prices is impossible.

© Pearson Education, 2005 What is Monopolistic Competition? (2) Product Differentiation Firms in monopolistic competition practice product differentiation. Product differentiation means that each firm makes a product that is slightly different from the products of competing firms. A differentiated product is a close substitute but not a perfect substitute.

© Pearson Education, 2005 What is Monopolistic Competition? (3) Competing on Quality, Price, Marketing and Branding Product differentiation enables firms to compete in four area: Quality: Product design, reliability, and service. Price: Because firms produce differentiated products, each firm has a downward-sloping demand curve for its own product. So, like monopoly, each firm can set its price and output. But there is a tradeoff between price and quality. Marketing and Branding Differentiated products must be marketed using advertising and packaging. Branding is the main way firms seek to establish quality differences.

© Pearson Education, 2005 What is Monopolistic Competition? (4) Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. Examples of Monopolistic Competition Some examples of monopolistic competition are audio and video equipment, computers, frozen foods, canned foods, book printing, clothing and dry cleaning.

© Pearson Education, 2005 Output and Price in Monopolistic Competition The Firm’s Short-run Output and Price Decision A firm that has decided the quality of its product and its marketing program produces the profit- maximizing 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-maximizing quantity.

© Pearson Education, 2005 Output and Price in Monopolistic Competition The firm produces the quantity at which price equals marginal cost and sells that quantity for the highest possible price. It earns an economic profit (as in this example) when P > ATC.

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Output and Price in Monopolistic Competition Long Run: Zero Economic Profit In the long run, economic profit induces entry. Entry continues as long as firms in the industry make an economic profit  as long as (P > ATC). In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC.

© Pearson Education, 2005 Output and Price in Monopolistic Competition Figure 13.3 shows a firm in monopolistic competition in long-run equilibrium. If in the short run firms incur an economic loss, some firms will exit until long-run equilibrium is restored.

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Output and Price in Monopolistic Competition Monopolistic Competition and Perfect Competition Two key differences between monopolistic competition and perfect competition are:  Excess capacity  Mark up A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. A firm’s mark up is the amount by which its price exceeds its marginal cost.

© Pearson Education, 2005 Output and Price in Monopolistic Competition Firms in monopolistic competition operate with excess capacity in long-run equilibrium. The downward-sloping demand curve for their products drives this result. Firms in monopolistic competition operate with positive mark up. Again, the downward-sloping demand curve for their products drives this result.

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Output and Price in Monopolistic Competition Is Monopolistic Competition Efficient? Because in monopolistic competition P > MC, marginal benefit exceeds marginal cost and monopolistic competition seems to be inefficient. But the mark up of price above marginal cost arises from product differentiation. People value variety, but variety is costly. Monopolistic competition brings the profitable and possibly efficient amount of variety to market.

© Pearson Education, 2005 Product Development and Marketing Innovation and Product Development We’ve looked at a firm’s profit-maximizing output decision in the short run and the long run of a given product and with given marketing effort. To keep making 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.

© Pearson Education, 2005 Product Development and Marketing Advertising Expenditures Firms in monopolistic competition incur heavy advertising expenditures. Figure 13.5 shows UK advertising expenditures for a range of industries in 2000.

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Product Development and Marketing Selling Costs and Total Costs Selling costs, like advertising expenditures, fancy retail buildings etc. are fixed costs. Average fixed costs decrease as production increases, so selling costs increase average total costs at any given level of output but do not affect the marginal cost of production. Selling efforts such as advertising are successful if they increase the demand for the firm’s product.

© Pearson Education, 2005 Product Development and Marketing Advertising costs might lower the average total cost by increasing equilibrium quantity and spreading their fixed costs over the larger quantity produced. Here, with no advertising, the firm produces 25 jackets at an average total cost of £60 a jacket.

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Product Development and Marketing With advertising, the firm produces 100 jackets at an average total cost of £40 a jacket. The advertising expenditure shifts the average total cost curve upward, but the firm produces a larger quantity and at a lower ATC than it would without advertising.

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Product Development and Marketing Selling Costs and Demand Advertising might also decrease the mark up. In Figure 13.7(a), with no advertising, demand is not very elastic and the mark up is large. In Figure 13.7(b), advertising makes demand more elastic, increases the quantity and lowers the price and mark up.

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Product Development and Marketing Using Advertising to Signal Quality Why does Gillette spend huge amounts of money every month advertising shavers that everyone knows? One answer is that Gillette uses advertising to signal the high quality of its shavers. A signal is an action taken by an informed person or firm to send a message to uninformed persons.

© Pearson Education, 2005 Product Development and Marketing Brand Names Why do firms spend millions of pounds to establish a brand name or image? Again, the answer is to provide information about quality and consistency. You’re more likely to overnight at a Sheraton than at Joe’s Shack because Sheraton has incurred the cost of establishing a brand name and you know what to expect if you stay there.