Monopolistic Competition or … An economic view of the wide world between Perfect Competition and Pure Monopoly

Monopolistic Competition The study of which will help us answer one of life’s great mysteries. Why in the world do we have so many: Fast food places Fast food places Gas stations Gas stations Coffee shops Coffee shops Clothing retailers … ? Clothing retailers … ?

Monopolistic Competition Characteristics: Numerous participants Numerous participants Freedom of exit and entry Freedom of exit and entry Perfect information Perfect information Heterogeneous (or differentiated) products Heterogeneous (or differentiated) products

Sound Familiar? Which of the characteristics of Monopolistic Competition match those of Perfect Competition?

Characteristics Numerous participants Numerous participants Freedom of entry and exit Freedom of entry and exit Perfect information Perfect information Heterogeneous (or differentiated) products Heterogeneous (or differentiated) products  Perfect Competition assumes all products from different firms are identical  Under Monopolistic Competition each seller’s product is perceived by the buyer as somewhat different from the products of other sellers

How are Products Differentiated? Fast Food Fast Food  Location  Product “quality”  Brand image Coffee Shops Coffee Shops  Location/convenience  Product taste/quality  Store atmosphere

Note Regarding Product Differentiation Buyer’s perception of difference is what is important – the “reality” of the difference is irrelevant Buyer’s perception of difference is what is important – the “reality” of the difference is irrelevant Reverse is also true – a “real” difference in product quality or performance that is not perceived or recognized by consumers is irrelevant Reverse is also true – a “real” difference in product quality or performance that is not perceived or recognized by consumers is irrelevant What does this imply about the “value” of advertising to producers and consumers? What does this imply about the “value” of advertising to producers and consumers?

Monopolistic vs. Perfect Competition Demand curve for a firm operating in a perfectly competitive market is ____________. Demand curve for a firm operating in a perfectly competitive market is ____________. Why? Why? If products are differentiated in a monopolistically competitive market – what does this imply about the shape of the demand curve for a firm operating in a “MC” market? If products are differentiated in a monopolistically competitive market – what does this imply about the shape of the demand curve for a firm operating in a “MC” market?

MC Market Demand Curves Demand curve for a firm in a monopolistically competitive market slopes down Demand curve for a firm in a monopolistically competitive market slopes down Product differentiation (think brand loyalty) reduces the impact of price changes on consumer behavior Product differentiation (think brand loyalty) reduces the impact of price changes on consumer behavior

MC Demand Curve vs. Monopoly Demand curve for a monopoly also slopes down Demand curve for a monopoly also slopes down But, slope of the curve is steeper for a monopoly vs. a firm operating in a monopolistically competitive market But, slope of the curve is steeper for a monopoly vs. a firm operating in a monopolistically competitive market Why? Why? Fewer (or no) substitute products and little choice for consumers translates into less buyer reaction in response to price movements Fewer (or no) substitute products and little choice for consumers translates into less buyer reaction in response to price movements

Between Monopoly and PC In a monopolistically competitive market, brand loyalty and product differentiation create small (often localized) monopolies In a monopolistically competitive market, brand loyalty and product differentiation create small (often localized) monopolies But, these monopolistically competitive firms face competitive pressure from many (imperfect) substitute products But, these monopolistically competitive firms face competitive pressure from many (imperfect) substitute products What does this imply about the ability of monopolistic competitors to earn above market economic returns? What does this imply about the ability of monopolistic competitors to earn above market economic returns?

What Have You Learned About Economic Profit? Firms operating in perfectly competitive markets maximize profit so that P = MC Firms operating in perfectly competitive markets maximize profit so that P = MC Competitive pressures in the form of new entrants push down prices until P = AC Competitive pressures in the form of new entrants push down prices until P = AC In the long run, firms operating in perfectly competitive markets cannot earn excess returns (P = MC = AC) In the long run, firms operating in perfectly competitive markets cannot earn excess returns (P = MC = AC) Graph Graph

Other Fun Facts About Economic Returns Monopolies can maximize their profits by producing to the point where marginal revenue (MR) equals marginal cost (MC) Monopolies can maximize their profits by producing to the point where marginal revenue (MR) equals marginal cost (MC) Without competitive pressure, monopolies can earn excess returns (represented by D – AC) over the long run Without competitive pressure, monopolies can earn excess returns (represented by D – AC) over the long run Graph Graph

Back to Our Original Question Similar to monopolies, monopolistic competitors maximize profit in the short run by producing to the point where MC = MR (think small, or local, monopolies) Similar to monopolies, monopolistic competitors maximize profit in the short run by producing to the point where MC = MR (think small, or local, monopolies) This results in excess returns in the short run This results in excess returns in the short run Graph Graph

But, There is Always the Long Run Similar to perfect competition, excess returns attract new entrants to the market (McDonalds/Wendy’s; Starbucks/Caribou; Exxon/BP) Similar to perfect competition, excess returns attract new entrants to the market (McDonalds/Wendy’s; Starbucks/Caribou; Exxon/BP) These might not be perfect substitutes in the minds of every consumer, but these new entrants will shift the demand curve downward until long run equilibrium is achieved (P = AC) These might not be perfect substitutes in the minds of every consumer, but these new entrants will shift the demand curve downward until long run equilibrium is achieved (P = AC) Graph Graph

Excess Capacity Theorem Note that D intersects AC at a point where average costs were still declining (AC curve sloping down) Graph Note that D intersects AC at a point where average costs were still declining (AC curve sloping down) Graph Remember in a perfectly competitive market equilibrium occurs at the low point on the AC curve Remember in a perfectly competitive market equilibrium occurs at the low point on the AC curve This implies that in monopolistically competitive markets: (1) unit costs are higher and (2) there is excess capacity and greater inefficiency This implies that in monopolistically competitive markets: (1) unit costs are higher and (2) there is excess capacity and greater inefficiency

Implications for Consumers If monopolistically competitive firms merge costs would go down and efficiency would go up (usually a good thing for consumers) If monopolistically competitive firms merge costs would go down and efficiency would go up (usually a good thing for consumers) Examples Examples But, choices would be also be reduced (fewer fast food and coffee shop choices) But, choices would be also be reduced (fewer fast food and coffee shop choices) Tradeoff between efficiency (lower costs) and standardization Tradeoff between efficiency (lower costs) and standardization

Summary Monopolistic competitors offer heterogeneous products (as perceived by buyers) Monopolistic competitors offer heterogeneous products (as perceived by buyers) Similar to monopolies, firms operating in monopolistically competitive markets may realize excess returns in the short run Similar to monopolies, firms operating in monopolistically competitive markets may realize excess returns in the short run In the long run new entrants will squeeze out excess returns and drive prices down until P =AC In the long run new entrants will squeeze out excess returns and drive prices down until P =AC Theoretical inefficiency is probably not a bad tradeoff given consumer preference for variety and choice Theoretical inefficiency is probably not a bad tradeoff given consumer preference for variety and choice