Copyright©2004 South-Western Mods Monopolistic Competition & Advertising

Copyright © 2004 South-Western Imperfect Competition Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly—monopolistic competition and oligopoly.

Copyright © 2004 South-Western One Type of an Imperfectly Competitive Market Monopolistic Competition Markets that have some features of competition and some features of monopoly. Attributes of Monopolistic Competition Many sellers Differentiated (similar but different) Relatively Easy entry and exit Some amount of Price-setting power Considerable non-price competition (Advertising)

Copyright © 2004 South-Western Monopolistic Competition Many Sellers There are many firms competing for the same group of customers. Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc.

Copyright © 2004 South-Western Monopolistic Competition Product Differentiation Each firm produces a product that is at least slightly different from those of other firms. This makes their product, however slightly unique, a market of 1—so there is no larger market graph Therefore, like a monopoly, they are the market for their good, so each firm faces a downward-sloping demand curve.

Copyright © 2004 South-Western Monopolistic Competition Free Entry or Exit Firms can enter or exit the market without restriction. The number of firms in the market adjusts until economic profits are zero.

Copyright © 2004 South-Western Monopolistic Competition— the “bare bones” graph Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Profit- maximizing quantity Price Demand MR MC

Monopolistic Competition in the Short Run—Profit scenario Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Profit- maximizing quantity Price Demand MR ATC Firm Makes Profit Average total cost Profit MC

Copyright © 2004 South-Western MC Firm earning Profits—what happens? Short-run economic profits encourage new firms to enter the market. This: Increases the number of products offered. Reduces demand faced by firms already in the market. Incumbent firms’ demand curves shift to the left. Demand for the incumbent firms’ products fall, and their profits decline.

Monopolistic Competitors in the Short Run—Loss Scenario Copyright©2003 Southwestern/Thomson Learning Demand Quantity 0 Price Loss- minimizing quantity Average total cost Firm Makes Losses MR Losses ATC MC

Copyright © 2004 South-Western MC Firm earning Losses— What Happens? Short-run economic losses encourage firms to exit the market. This: Decreases the number of products offered. Increases demand faced by the remaining firms. Shifts the remaining firms’ demand curves to the right. Increases the remaining firms’ profits.

A Monopolistic Competitor in the Long Run Copyright©2003 Southwestern/Thomson Learning Quantity Price 0 Demand MR ATC MC Profit-maximizing quantity P =ATC

Copyright © 2004 South-Western The Long-Run Equilibrium Firms will enter and exit until the firms are making exactly zero economic profits. As in a competitive market, in the long run, price equals average total cost.

Monopolistic versus Perfect Competition— Long Run Equilibrium Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) Perfectly Competitive Firm MC ATC MC ATC MR Marginal cost P Quantity produced Quantity produced

Copyright © 2004 South-Western Monopolistic versus Perfect Competition There are two noteworthy differences between monopolistic and perfect competition—excess capacity and markup.

Copyright © 2004 South-Western Monopolistic versus Perfect Competition Excess Capacity For PC firms, free entry in response to market conditions produces a LR Equilibrium that has the firm producing where MR=MC=ATC. This is the efficient scale for the firm. For MC firms, LR Equilibrium has firm producing where DARP =ATC, but this is not at ATC’s lowest point, so output is less than the efficient scale of perfect competition.

Monopolistic versus Perfect Competition Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) Perfectly Competitive Firm MC ATC MC ATC MR Efficient scale P Quantity produced Quantity produced = Efficient scale Excess capacity

Copyright © 2004 South-Western Monopolistic versus Perfect Competition Markup Over Marginal Cost For a PC firm, price equals marginal cost. For an MC firm, price exceeds marginal cost. Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm. This is just like monopoly, but because Monopoly firms are true “one-of-a-kind” products, they will always “markup” to the DARP curve. Due to competition, MC firms may vary their markup

Copyright © 2004 South-Western Monopolistic versus Perfect Competition Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) Perfectly Competitive Firm Markup MC ATC MC ATC MR Marginal cost P Quantity produced Quantity produced

Monopolistic versus Perfect Competition Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) Perfectly Competitive Firm Markup Excess capacity MC ATC MC ATC MR Marginal cost Efficient scale P Quantity produced Quantity produced = Efficient scale

Copyright © 2004 South-Western Monopolistic Competition and the Welfare of Society Monopolistic competition does not have all the desirable properties of perfect competition.

Copyright © 2004 South-Western Deadweight loss Just like monopoly pricing, MC’s have deadweight loss caused by the markup of price over marginal cost. However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming. We see this DW loss as the “cost of variety” Monopolistic Competition and the Welfare of Society

Copyright © 2004 South-Western Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry. Monopolistic Competition and the Welfare of Society

Copyright © 2004 South-Western Externalities(side effects) of entry include: product-variety externalities. business-stealing externalities. Monopolistic Competition and the Welfare of Society

Copyright © 2004 South-Western The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality (or side effect) on consumers. The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality (or side effect) on existing firms. Monopolistic Competition and the Welfare of Society

Copyright © 2004 South-Western ADVERTISING (Non-Price Competition) When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product.

Copyright © 2004 South-Western Product Differentiation Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry.

Copyright © 2004 South-Western Product Differentiation Ways to Differentiate: REAL physical appearance/qualities Location Services Perceived Differences

Copyright © 2004 South-Western ADVERTISING Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising. In 2014, about $.5 Trillion spent on advertising

Copyright © 2004 South-Western ADVERTISING The Critique of Advertising: Firms advertise in order to manipulate people’s tastes. Advertising impedes competition by implying that products are more different than they truly are. Brand names also cause consumers to perceive differences between products that don’t really exist.

Copyright © 2004 South-Western ADVERTISING The Defense of Advertising: Advertising provides information to consumers Advertising increases competition by offering a greater variety of products and prices. Advertising dollars can be a signal to consumers about the quality of the product being offered. Brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality by providing information about quality. giving firms incentive to maintain high quality.