Chapter 11 Monopolistic Competition and Product Differentiation

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Assumptions of the Monopolistic Competition Model Free entry and exit in the long run  No barriers to entry Many firms, each one small relative to the size of the market  Firms will have limited market power. Each firm produces a differentiated product  Consumers view the goods as close substitutes, but not perfect substitutes.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Short-Run Profit Maximization for the Monopolistic Competitor Product differentiation creates a small amount of market power due to customer loyalty.  Even if the firm raises its price, it will still retain some of its customers.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Economic Efficiency Is a monopolistic competitive industry  Allocatively efficient?  Productively efficient?  Technologically efficient?

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 11.3 Short-Run Profits

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Loss Minimization and the Shut-Down Point If demand decreases or costs increase, profits will fall.  If the demand curve just touches the ATC curve at the profit-maximizing level of output, the firm will earn normal economic profits.  If the demand curve just touches the AVC curve at the profit-maximizing level of output, the firm will be indifferent between operating and shutting down.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 11.4 Minimizing Losses and Reaching the Shutdown Point

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Monopolistic Competition in the Long Run In the short run, monopolistically competitive firms behave much like a monopolist. In the long run, however, monopolistic competition differs from monopoly because of free entry into the market.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Firm Entry in Monopolistic Competition If firms in a monopolistically competitive market are earning positive economic profits, then new firms will enter the market.  Similar to perfect competition

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 11.5 Effects of New Entrants on the Demand for Cheesesteaks at John’s Roast Pork

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Firm Entry in Monopolistic Competition An important difference between monopolistic competition and perfect competition is that price does not fall to the minimum point on the long-run average cost curve.  The firms are not efficient.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Summary of Monopolistic Competition Each firm maximizes profits by producing the output for which MR = MC.  Price is determined by the demand curve. Long-run entry implies that firms will be driven towards zero economic profits in the long run.  P = LAC Price will be greater than the minimum point of LAC. Firms have different demand and costs, leading to long-run turnover of firms.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Allocative Efficiency For monopolistically competitive firms, the profit-maximizing level of output is less than that which minimizes LAC.  Monopolistically competitive firms are not as efficient as perfectly competitive firms.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 11.6 The Long-Run Monopolistic Competition Equilibrium Versus the Perfect Competition Equilibrium

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Excess Capacity As a result of underproduction at both the firm and industry level, monopolistically competitive firms are said to exhibit excess capacity.  Output could be increased without any firms earning losses.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The Benefits of Variety Is the reduction in efficiency associated with monopolistic competition bad for society? Not necessarily:  Because consumers value variety, the benefits of product differentiation may offset the costs of excess capacity.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Table 11.1 Summary of Market Structure Characteristics for Perfect Competition, Monopolistic Competition, and Monopoly

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Advertising: Information or Persuasion? Unlike perfectly competitive firms or monopolists, monopolistically competitive firms will advertise to inform customers about their product.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Brand Identity and Brand Loyalty The goal of advertising is to create:  Brand Identity—the consumer’s ability to recognize a product and associate it with a specific name.  Brand Loyalty—a consumer’s willingness to remain with a specific product despite the existence of competing products. Makes demand less elastic

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Types of Advertising Informational—increases consumers’ knowledge of important product characteristics and price. Persuasive—attempts to alter consumer tastes and preferences by using subjective information.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 11.7 Effect of Advertising on the Demand for John’s Cheesesteaks

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Advertising Product Characteristics Product characteristics will determine how a product is advertised.  Search goods have characteristics that can be described and easily verified by consumers. Advertised through informational advertising  Experience goods have to be consumed before a consumer can determine their characteristics. Advertised using persuasive advertising

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Life Lessons Taste tests show that most consumers cannot tell the difference between colas.  Think twice before paying full price for a brand name soda.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Strategy and Policy Something old, something new, all in the same box.  Cereal manufacturers believed that changing the names of cereals might make people think they were not purchasing high-sugar content cereal.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Summary Monopolistic competition is defined as a large number of firms producing a differentiated product in a market with free entry. A monopolistically competitive firm maximizes profit by producing the level of output for which MR = MC.  Price is then determined by the demand curve.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Summary (cont’d) In the long run, because of free entry and exit, monopolistically competitive firms will earn zero economic profits. Monopolistically competitive firms are less efficient than perfectly competitive firms.  Excess capacity Product differentiation offsets some of the loss of efficiency.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Summary (cont’d) Firms use adverting to differentiate their product from competing products.  Informational  Persuasive