1. Chapter 25 Monopolistic Competition

2. Introduction
John Locke is the author of crime-adventure e-books selling for 99 cents at Amazon’s website. When he saw that successful authors were charging $9.99 for their e-books, he expressed a confidence that he would have customers who feel that the other books are not necessarily ten times better than his.
E-books are an example of a product that exhibits product differentiation, a fundamental characteristic of monopolistic competition. In this chapter, you will learn why the growing importance of e-books has complicated the process of selling both e-books and physical books.

3. Learning Objectives
Discuss the key characteristics of a monopolistically competitive industry
Contrast the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms

4. Learning Objectives (cont'd)
Explain why brand names and advertising are important features of monopolistically competitive industries
Describe the fundamental properties of information products and evaluate how the prices of these products are determined under monopolistic competition

5. Chapter Outline Monopolistic Competition
Price and Output for the Monopolistic Competitor
Comparing Perfect Competition with Monopolistic Competition
Brand Names and Advertising
Information Products and Monopolistic Competition

6. Did You Know That …
A company called J & D Foods offers bacon-flavored and turkey-and-gravy-flavored soft drinks?
And you can buy bottled water in flavors of Buffalo wings, cheeseburger, and fish and chips?
Product heterogeneity, variations in product characteristics, and advertising did not show up in our analysis of perfect competition.
These are features of monopolistic competition— the subject of this chapter.

7. Monopolistic Competition
In the 1920s and 1930s, economists were aware of industries that did not fit under perfect competition or pure monopoly
Theoretical and empirical research was instituted to develop some sort of middle ground

8. Monopolistic Competition (cont'd)
Two separately developed models of monopolistic competition resulted
At Harvard, Edward Chamberlin published Theory of Monopolistic Competition in 1933
That same year, Joan Robinson of Cambridge published The Economics of Imperfect Competition

9. Monopolistic Competition (cont'd)
A market situation in which a large number of firms produce similar but not identical products
Entry into the industry is relatively easy

10. Monopolistic Competition (cont'd)
Characteristics of monopolistic competition
Significant numbers of sellers in a highly competitive market
Differentiated products
Sales promotion and advertising
Easy entry of new firms in the long run

11. Monopolistic Competition (cont'd)
Implications of the large number of firms
Small market share
Lack of collusion
Independence

12. Monopolistic Competition (cont'd)
Product Differentiation
The distinguishing of products by brand name, color, and other minor attributes.

13. Monopolistic Competition (cont'd)
Product differentiation and price
The firm has some control over the price it charges
Unlike a perfect competitor, it faces a downward sloping demand curve
Consider the abundance of brand names for many products
The more successful the firm is at differentiation, the more control it has over price

14. Example: Is Punxsutawny Phil Hogging Too Much Attention?
Since 1887, Punxsutawny Phil, the groundhog residing in the Pennsylvania town of that name, has been used to predict the weather on February 2—the official Groundhog Day.
Today, there are at least 17 “groundhog lodges” in Pennsylvania and nearby states, each of which promotes its own groundhog’s weather-forecasting talents in an effort to attract tourists to their communities.

15. Monopolistic Competition (cont'd)
What do you think about advertising?
Would a perfect competitor have any incentive to advertise?
Why would a monopolistically competitive firm advertise?
Can advertising lead to efficiency?

16. Monopolistic Competition (cont'd)
Sales promotion and advertising
Can increase demand for a firm
Can differentiate a firm’s product
Can result in increased profits

17. Monopolistic Competition (cont'd)
Question
How much advertising should be undertaken?
Answer
It should be carried to the point at which the additional revenue from one more dollar of advertising just equals that one dollar of additional cost

18. Example: A Biodegradable Chips Bag is Crunchier Than the Chips
As part of its product differentiation, the snack-food company Frito-Lay designed a biodegradable bag for its Sun Chips brand.
The bag also produces a loud crunching sound when squeezed.
Frito-Lay has incorporated the crunchiness of this bag into its marketing, as a way of distinguishing Sun Chips from competing products.

19. Monopolistic Competition (cont'd)
Ease of entry
For any current monopolistic competitor, potential competition is always lurking in the background
The easier—that is, the less costly—entry is, the more a current competitor must worry about losing business

20. Price and Output for the Monopolistic Competitor
The individual firm’s demand and cost curves
Demand curve slopes downward
Profit maximized where MC intersects MR from below

21. Price and Output for the Monopolistic Competitor (cont'd)
Short-run equilibrium
In the short run, it is possible for a monopolistic competitor to make economic profits—profits over and above the normal rate of return, or beyond what is necessary to keep that firm in the industry
Losses in the short run are clearly also possible

22. Price and Output for the Monopolistic Competitor (cont'd)
The long run: zero economic profits
The rate of return will tend toward normal
Economic profits will tend toward zero
So many firms produce substitutes, any economic profits will disappear with competition
Reduced to zero either through entry of new firms seeking to earn a higher rate or return, or by changes in product quality and advertising outlays by existing firms

23. Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (a)

24. Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (b)

25. Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (c)

26. Comparing Perfect Competition with Monopolistic Competition
Question
If both a monopolistic and perfect competitor make zero economic profit in the long run, how are they different?
Answer
Demand curve for individual perfect competitor is perfectly elastic

27. Figure 25-2 Comparison of the Perfect Competitor with the Monopolistic Competitor

28. Comparing Perfect Competition with Monopolistic Competition (cont'd)
In perfect competition, the long-run equilibrium occurs where average total cost is minimized (this does not occur in monopolistic competition)
Some have argued that this is not necessarily a waste of resources—as the added cost arises from product differentiation
Chamberlin argued it is rational for consumers to have a taste for differentiation; consumers willingly accept the resultant increased production costs in return for more choice and variety of output

29. Brand Names and Advertising
Because “differentness” has value for consumers, monopolistically competitive firms regard their brand names as valuable private (intellectual) property
Firms use trademarks, words, symbols, and logos to distinguish their product brands from goods or services sold by other firms
A successful brand image contributes to a firm’s profitability

30. Brand Names and Advertising (cont'd)
Brand names and trademarks
A company’s value in the marketplace depends largely on current perceptions of future profitability
We can see it in the market value of the world’s most valuable product brands
Valuation depends on the market prices of shares of stock of a company times the number of shares traded

31. Table 25-1 Values of the Top Ten Brands

32. Methods of Advertising
Direct Marketing
Advertising targeted at specific consumers: , regular mail
Mass Marketing
Advertising intended to reach as many customers as possible: radio, TV, newspaper
Interactive Marketing
Permits consumer to follow up directly by searching for more information

33. International Example: A Push to Make Electronic Billboards Interactive in Japan
In Japan, when a person glances at an electronic advertising display, the ad often looks back with a mechanism that can determine the age and gender of the person.
Based on the individual’s characteristics, the display will recommend a specific product tailored to individual needs.

34. Figure 25-3 Distribution of U.S. Advertising Expenses

35. Informational Versus Persuasive Advertising
Search Good
A product with characteristics that enable an individual to evaluate the product’s quality in advance of a purchase
Experience Good
A product that an individual must consume before the product’s quality can be established
Credence Good
A product with qualities that consumers lack the expertise to assess without assistance

36. Brand Names and Advertising
Examples of search goods
Clothing and music evaluated prior to purchase
Examples of experience goods
Soft-drinks, restaurants, movies
Examples of credence goods
Health care, legal advice

37. Brand Names and Advertising (cont'd)
Informational Advertising
Advertising that emphasizes transmitting knowledge about the features of a product
Persuasive Advertising
Advertising that is intended to induce a consumer to purchase a particular product and discover a previously unknown taste for an item

38. Brand Names and Advertising (cont'd)
Advertising as a signaling behavior
Individual companies can explicitly engage in signaling behavior
They do so by establishing brand names or trademarks and promoting them

39. What If … the government were to limit or even ban “excessive” advertising?
Informational advertising is informative to buyers of search goods.
Even a firm’s expenditures on persuasive advertising communicate an intention to continue its operations for the foreseeable future.
Any attempt to restrict the amount of advertising would reduce the informational benefits to society.

40. Information Products and Monopolistic Competition
Information products, such as computer operating systems, software, and digital music and videos, have a unique cost structure
Product development entails high fixed costs, but the marginal cost of producing a copy for one more customer is low

41. Information Products and Monopolistic Competition (cont'd)
An item that is produced using information- intensive inputs at a relatively high fixed cost but distributed for sale at a relatively low marginal cost

42. Figure 25-4 Cost Curves for a Producer of an Information Product

43. Information Products and Monopolistic Competition (cont'd)
Short-Run Economies of Operation
A distinguishing characteristic of an information product arising from declining short-run average total cost as more units of the product are sold

44. Information Products and Monopolistic Competition (cont'd)
Consider how computer game manufacturers operate in a monopolistically competitive market.
In monopolistic competition, marginal cost pricing results in losses for the firm, even though it creates efficiencies for the economy as a whole.

45. Information Products and Monopolistic Competition (cont'd)
Providing an information product entails incurring relatively high fixed costs, but a relatively low per-unit cost for additional units of output
The ATC for a firm that sells an information product slopes downward, meaning the firm experiences short-run economies of operation
In a long-run monopolistically competitive equilibrium, price adjusts to equal ATC; the firm earns sufficient revenues to cover total costs, including the opportunity cost of capital
Consumers thereby pay the lowest price necessary to induce sellers to provide the item

46. Figure 25-5 The Infeasibility of Marginal Cost Pricing of an Information Product

47. You Are There: Have You Smelled a Ford Lately?
Linda Schmalz, a body interior materials engineer at Ford Motor Company, is responsible for determining the appropriate odors for accessories within the passenger compartment of Ford vehicles.
Schmalz has discovered that there are regional differences in people’s perception of odors.
This has prompted her to think about offering customized scents as a way of creating product differentiation for Ford vehicles.

48. Issues & Applications: Why E-Books Are Upending the Publishing Business
Book publishing exhibits many features of monopolistic competition.
Given the relatively high fixed cost of authoring a book, publishers also face downward-sloping average total cost curves.
Variable costs are much lower for e-books, and this alternative has caused a decrease in demand for physical books.
The likely consequence is that some publishers of physical books will experience economic losses and may therefore exit the industry.

49. Summary Discussion of Learning Objectives
Key characteristics of a monopolistically competitive industry
Large number of small firms
Differentiated products
Easy entry and exit
Advertising and sales promotion

50. Summary Discussion of Learning Objectives (cont'd)
Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms
Monopolistically competitive firm in short run
Produces output to point MR = MC in short run
Price set on demand curve, can be less than MC and ATC in short run, firm earns economic profits

51. Summary Discussion of Learning Objectives (cont'd)
Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms
Monopolistically competitive firm in the long run
Price = ATC in the long run as firms enter industry
Like perfectly competitive firms, earns zero economic profits in long run
Price exceeds MC in long run

52. Summary Discussion of Learning Objectives (cont'd)
Monopolistically competitive firms attempt to boost demand for their products through product differentiation
They engage heavily in advertising and marketing
Providing an information product entails incurring relatively high fixed costs but low marginal costs
In the long run equilibrium, price adjusts to equality with average total cost