1. Monopolistic Competition and Advertising
Pre-class music: Advertising in Super Bowl Commercials (See Tip #418)
Instead of playing the usual pre-class music, you could introduce this chapter by playing a montage of famous/funny commercials (possibly a top 10 commercial list on YouTube) to prime your class for a discussion on the importance of advertising.
Pre-class video: Kohl’s commercial, “Black Friday” (See Tip #437)
You could also start out your lecture on this chapter by showing this Kohl’s commercial, which parodies Rebecca Black’s polarizing song “Friday.”
The key concepts covered in this commercial include:
Product differentiation
Advertising

2. Previously Price discrimination General rule for price discrimination:
Occurs when a firm charges buyers different prices for the same good or service
Increases firm profits and total welfare
General rule for price discrimination:
Charge higher (lower) prices to consumers with relatively inelastic (elastic) demands.
Lecture notes:
Recall the conditions necessary for a firm to be able to price discriminate:
Market power—price maker
Ability to separate consumers based on willingness to pay
Have to be able to prevent resale

3. Practice What You Know—1
Which of the following industries fits most closely with the model of monopolistic competition?
automobile production
farming
diamond mining
fast-food restaurants
Lecture tip:
Mix things up a bit by asking a few questions before beginning the lecture!
Clicker question:
Correct answer: D, fast-food restaurants
We’re looking for an industry with a lot of competitors offering imperfectly substitutable products.

4. Practice What You Know—2
Which of the following is a monopolistic competitor?
a local farm that grows Granny Smith apples
your local electric company
a big and tall clothing store
General Motors
Clicker question:
Correct answer: C, Big & Tall Clothing
We’re looking for an industry with a lot of competitors offering imperfectly substitutable products.

5. Practice What You Know—3
Which of the following is true about monopolistic competition?
It results in higher prices than monopoly.
It results in higher prices than perfect competition.
It results in lower quantity than monopoly.
It is more economically efficient than perfect competition.
Clicker question:
Correct answer: B, It results in higher prices than perfect competition.
Monopolistic competition has higher prices and lower output compared to perfect competition; monopolistic competition has lower prices and higher output compared to monopoly.
Perfect competition is the most efficient market structure, where P = min(ATC) in equilibrium, and there is no deadweight loss.

6. Big Questions What is monopolistic competition?
What are the differences among monopolistic competition, competitive markets, and monopoly?
Why is advertising prevalent in monopolistic competition?
Lecture notes:
As its name would suggest, monopolistic competition takes part of two previous models:
It behaves like a monopoly in that it is a price maker.
It performs like perfect competition in that long-run economic profit is equal to zero.

7. What Is Monopolistic Competition?
Market structure:
Many different firms
Products are differentiated
Free entry and exit
Product differentiation
Process that firms use to make a product more attractive by contrasting its unique qualities with competing products
Lecture notes:
Some examples of monopolistic competition can include:
Fast-food restaurants
Clothing retailers
Gas stations
Hair salons
Product differentiation:
Goods are imperfect substitutes—“the same but different.”
Note that differentiation can be real or spurious.
A firm’s goal here is to convince consumers that its product is better than the competitors’.
A highly differentiated product may even command a higher demand and price.

8. Comparing Market Structures
Perfectly Competitive Markets
Monopolistic Competition
Monopoly
Many sellers
One seller
Similar products
Differentiated products
A unique product without close substitutes
Free entry and exit
Low barriers to entry and exit
Barriers to entry and exit
Lecture notes:
So far, we have talked about two “extreme” market structures.
Perfect competition:
Each firm has zero market power and is a price taker.
Each firm faces a horizontal demand curve.
Because of free entry, a competitive firm earns zero economic profits in the long run.
Monopoly:
A monopoly has market power and is a price maker.
It faces a downward-sloping demand curve.
Because of barriers, a monopoly can earn economic profits in the long run.
Monopolistic competition:
Many sellers like perfect competition.
Since firms sell a differentiated product, firms face downward-sloping demand curve like a monopoly.
Each firm has some market power, but it is limited since there are many sellers.
Monopolistic competition would be closer to perfect competition than monopoly.

9. Product Differentiation—1
What are some ways firms differentiate their products?
Style or type
Location
Quality
Lecture notes:
Style or type:
Abercrombie & Fitch and Hollister target a young/trendy demographic.
Ann Taylor, Bon-Ton, and J.C. Penney aim for a more adult consumer type.
Dick’s Sports and Big Five Sport
Restaurants of all ethnic types to satisfy different consumer tastes
Location:
Even if the product is very similar, convenient locations may give some firms pricing power.
Quality:
Quality differentiation allows firms to capture consumers that have not only different tastes but also different incomes or willingness to pay.
[Crosswalk: © TravelCollection/Alamy Stock Photo;; Urban Outfitters: © Jen Grantham/iStockphoto.com; Chipotle: Marcnorman | Dreamstime.com; Taco Bell: © swalls/i-Stock.com]

10. Product Differentiation—2
Important point to remember:
De gustibus non est disputandum or
“In matters of taste, there can be no disputes”
“Beyond the Book” Slide
Lecture notes:
As an economist, your job is not to dispute (criticize) consumer tastes. They are what they are.
Your job is to explain how firms respond given those tastes.
It is true that advertising influences tastes. Absent of false advertising (we will address this later), if consumers think the products are different, and get more satisfaction from consuming product A over B, economists should not judge.

11. Economics in Seinfeld, “The Café”
Babu’s restaurant has few customers, so Jerry convinces Babu to serve Pakistani food.
“Economics in the Media” Slide
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
The key concepts covered in this clip are:
Product differentiation
Free entry and exit
Monopolistic competition

12. Economics in American Gangster
“Blue Magic”—a brand that signals quality
“Economics in the Media” Slide
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
This clip provides an interesting illustration of how firms signal quality of a product through branding (in this case, the product is heroin). The other key concepts covered in this clip are:
Competition
Collusion

13. Differences among the Three Market Types
Perfect competition:
Low prices
Efficient level of output
Monopoly:
High prices
Inefficient level of output
Monopolistic competition: ?
Lecture tip:
You may want to preview the answers:
Prices are higher than under perfect competition but lower than under monopoly.
Outcome is inefficient, but welfare loss is smaller than under monopoly.
Although inefficient compared to perfect competition, consumers get products that better match their tastes.

14. Monopolistic Competition in the Short Run
Image: Animated Figure 12.1
Lecture notes:
Here, we want to show:
How a monopolistically competitive firm decides how much output to produce to maximize profits
Whether the firm makes a profit or a loss
Note that in both diagrams, the cost curves are the same, but the demand in the right diagram is lower than in the left diagram.
Also note that it looks like a monopoly diagram. The key difference is that here, the demand curve is relatively elastic since there are many sellers.
First and second clicks:
Labels the profit-maximizing price, output, and ATC in both diagrams.
Third click:
Shades in the profit box.
Fourth click:
Shades in the loss box.

15. Monopolistic Competition in the Long Run—1
In the short run, a monopolistically competitive firm may earn profits or losses.
What will occur in the long run?
Why?
Lecture notes:
Since there is free entry and exit:
If there are short-run profits, new firms will enter.
A firm’s demand curve will decrease and become more elastic.
Entry will continue until profits are equal to zero.
If there are short-run losses, new firms will exit.
A firm’s demand curve will increase and become less elastic.
Exit will continue until profits are equal to zero.

16. Monopolistic Competition in the Long Run—2
Image: Animated Figure 12.2
Lecture notes:
Before clicking through the slide, ask students where to draw the ATC curve.
Note that the demand curve is drawn just tangent to the average total cost curve.
At this point, P = ATC, and profits are zero.

17. Monopolistic Competition and Competitive Markets—1
Price, Marginal Cost and Long-Run ATC Cost
Perfect competition: P = MC
Monopolistic competition: P > MC
Markup: P - MC
Perfect competition: P = min ATC
Monopolistic competition: P > min ATC
Lecture tip:
First, state the general rules (listed on the PowerPoint slide above), and then show the figures on next slide.
Markups are possible when a firm enjoys some market power and sells a differentiated product.
The more differentiated a product is, the higher the markup for that product.

18. LR Equilibrium in Two Market Structures—1
Image: Animated Figure 12.3
Lecture tip:
Here’s what you should point out regarding the figure on the slide above:
PMonComp > PPC
First click:
PMonComp > MC, so markup is P – MC.
Second click:
Draws dashed line tangent to min point of ATC
PMonComp > min ATC
Point out that this is because the monopolistically competitive firm faces a downward-sloping demand curve. P = ATC since the firm earns zero economic profit, but since the tangency occurs at an output less than at min ATC, P > min ATC.

19. Monopolistic Competition and Competitive Markets—2
Scale and output
Perfect competition:
In the long run, a firm produces at minimum efficient scale.
Monopolistic competition:
In the long run, a firm produces with excess capacity.
Lecture tip:
First, state the general rules (listed on the PowerPoint slide above), and then show the figures on next slide.

20. LR Equilibrium in Two Market Structures—2
Image: Animated Figure 12.3
Lecture tip:
First click:
Draws efficient scale in each diagram.
Second click:
Labels excess capacity.

21. On Scale and Output Why not produce more?
The firm would have to lower the price.
It is more profitable to produce at excess capacity.
Compare to perfect competition
Perfectly competitive firms operate at capacity at the minimum of ATC.
Overall output is higher in perfect competition.
Lecture notes:
Monopolistic competition produces less output at a higher price than perfect competition does. Graphically, you can see that due to the downward-sloping demand curve in monopolistic competition, the price = ATC at a higher point on the ATC curve.

22. Inefficiency and Social Welfare—1
Is monopolistic competition efficient? No
Two sources of inefficiency:
ATC is higher compared to perfect competition
Markup: P > MC
Lecture notes:
Inefficiency here can be thought of as:
Reduced number of transactions (compared to perfect competition)
Existence of DWL (compared to zero in perfect competition)
However, this inefficiency is small compared to monopoly inefficiency.
On ATC:
All else being equal, it would be better to have firms decrease price and increase their output to reduce ATC.
On MC:
Consumers would also benefit if the firms cut price and reduced the markup.
Cutting prices and expanding output are not practical since monopolistically competitive firms have no incentive to do so because that would reduce profits.

23. Inefficiency and Social Welfare—2
Should the government intervene?
Firms are not able to earn long-run profits since there are no barriers.
Regulation may put many firms out of business.
Less firms may mean more inconvenience and fewer choices for consumers.
Inefficiency is not large enough to warrant government intervention
Lecture notes:
In monopoly, we discussed how governments often intervene.
Could that also work with monopolistic competition?
Probably not.
The problems of inefficiency, market power, and high prices aren’t as big of an issue here.
In fact, intervention may make things worse.

24. Varying Degrees of Product Differentiation—1
How does the loss in efficiency relate to the degree of product differentiation?
“High” Degree
“Low” Degree
Lecture notes:
Not all monopolistic firms have the same amount of differentiation.
Some firms sell products that are very close substitutes to their competitors’ products.
Think about various pizza brands; most are pretty similar.
Other firms sell a product that is very differentiated but still somewhat substitutable with a competitor’s product.
This can be said about various clothing stores (Abercrombie & Fitch versus Old Navy).
Abercrombie & Fitch is highly differentiated with a higher markup.
T.J.Maxx, Ross, and other “lower”-end stores aren’t as differentiated.
[Urban Outfitters: © Jen Grantham/iStockphoto.com; Hollister: © TravelCollection/Alamy Stock Photo; Dominos: © Steve Shepard/iStockphoto.com; Pizza Hut: © Steve Shepard/iStockphoto.com]

25. Varying Degrees of Product Differentiation—2
A highly differentiated product means
Higher prices and markups
Larger excess capacity
A less-differentiated product means
Lower prices and markups
Less excess capacity

26. Differentiation, Excess Capacity, and Efficiency
Image: Animated Figure 12.4
Lecture notes:
Before clicking through the slide, ask students how to draw the demand curves in each situation.
First click:
If there is a high degree of product differentiation, the demand curve will be relatively inelastic or steep.
Firm A enjoys significant differentiation.
The firm has an especially attractive location, style, type, or quality of product that is in high demand among consumers, and it is not easily replicated by competitors.
H&M, Urban Outfitters, and Abercrombie & Fitch are good examples.
Second click:
If there is a low degree of product differentiation, the demand curve will be relatively elastic or flat.
Firm B sells a product that is only slightly different from its competitors’ products.
T.J.Maxx, Ross, and Marshalls are three companies that primarily sell discounted clothes.
Third click:
Labels LR equilibrium points for each firm.
In the long run, the firms earn zero economic profit, so the ATC curve is tangent to the demand curve.
At this point, ask students which firm operates with more excess capacity.
Fourth click:
Firm A operates with a relatively large excess capacity.
Fifth click:
Firm B operates with a relatively small excess capacity.
What does this tell us?
The more the degree of product differentiation, the greater the markup and excess capacity.
The less the degree of product differentiation, the smaller the markup and excess capacity.
Does this say product differentiation is a bad thing?

27. Is Inefficiency So Bad? Which Would You Prefer?—1
Situation A:
Pizza is produced in slightly higher quantities with slightly lower prices than it currently is.
However, all pizza is the same brand (all pizza restaurants are Pizza Hut, for example).
Real-world example: Is Inefficiency So Bad? (See Tip #428)
Lecture tip:
Present these two scenarios (Scenario A, on this slide, and Scenario B, on the next slide) to your students, and ask which is preferable.
[© Steve Shepard/iStockphoto.com]

28. Is Inefficiency So Bad? Which Would You Prefer?—2
Situation B:
Pizza is produced as it currently is today: slightly lower quantities with slightly higher prices (compared to under perfect competition). However, you have more variety and choice, and there are many different types and styles of pizza being made at different restaurants.
Real-world example: Is Inefficiency So Bad? (See Tip #428)
Lecture notes:
Situation A is meant to be perfectly competitive; Situation B, monopolistically competitive.
Note that there is a tradeoff with product differentiation:
Firms are able to charge higher prices, so all else being equal, consumers are worse off.
But firms produce a good or service that better matches consumer tastes, so consumers are better off.
[Pizza Hut: © Steve Shepard/iStockphoto.com; Pizza: © Serafino Mozzo/iStockphoto]

29. Economics in South Park, “Gnomes”
Harbucks moves into town, creating dire effects on the local coffee shop.
“Economics in the Media” Slide
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
This clip provides a nice example of the nature of competition. The other key concepts covered in this clip are:
Substitutes
Market power
Monopolistic competition
Barriers to entry

30. Practice What You Know—4
What is true about the long-run equilibrium for firms in a monopolistically competitive industry?
MR < MC, P < min(ATC)
P = MR = MC = min(ATC)
P = ATC, P > MC, P > min(ATC)
P > ATC, P = MC
Clicker question:
Correct answer: C, P = ATC, P > MC, P > min(ATC)
P = ATC means there are zero profits, but there is a markup (P > MC) and a little bit of inefficiency (P > min(ATC)).

31. Practice What You Know—5
Which of the following is true about product differentiation?
More differentiation means products are more substitutable for each other.
More differentiation leads to greater differences in price.
More differentiation leads to converging prices.
Differentiation lowers firm profits.
Clicker question:
Correct answer: B, More differentiation leads to greater differences in price.
The more different products are, the more prices can differ. Goods that are less and less substitutable can command different prices.
Higher quality, better location, better style, and so on lead to higher price.

32. Economics in E.T. the Extraterrestrial
Reese’s Pieces wins big with product placement.
“Economics in the Media” Slide
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
The key concepts covered in this clip are:
Monopolistic competition
Advertising
[Universal / The Kobal Collection/Art Resource, NY]

33. Economics in “Free Hugs Prank: $2 Deluxe Hugs”
Is a $2 hug better than a free hug?
“Economics in the Media” Slide
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
This prank illustrates how price can signal the quality of luxury brands.

34. Why Is Advertising Prevalent in Monopolistic Competition?—1
Why do firms advertise?
Change the demand for the product
Lecture notes:
How does advertising affect the firms’ demand curve?
Increases demand
Makes it more inelastic
[© rabbit75/iStockphoto.com]

35. Advertising and Demand
Image: Animated Figure 12.5
Lecture notes:
This simple graph shows the effect advertising has on demand for a product.
First click:
Draws new demand.
Demand increases (shifts right) in response to the additional demand created by the advertising.
The demand curve becomes more inelastic.
Advertising makes a product more attractive to specific customers who are now more likely to want it.
Since demand is more inelastic, the firm has more market power and can increase the price it charges.

36. Why Is Advertising Prevalent in Monopolistic Competition?—2
Why do firms advertise?
Increase demand for the product
Provide information to consumers
Form of non-price competition
Might signal quality
Lecture notes:
Information:
Price
Location
Features
Non-price competition:
Advertising is a way to differentiate your product from your rivals’ products.
Quality:
Based on argument that advertising is an investment
A profit-maximizing firm would not spend a great deal on advertising if it did not expect a reasonable return.
So, consumers can infer that the product advertised is of high quality.
[© rabbit75/iStockphoto.com]

37. Advertising in Different Markets—1
In which market(s) do we see more or less advertising?
Perfect competition
Firms that advertise will have higher costs than rivals, without any gains
Advertising at the industry level
Lecture notes:
Perfect competition:
Products are undifferentiated.
One firm advertising is like a public good—all other firms will gain—but the firm that incurs the advertising costs is now at a disadvantage.
At the industry level:
“Beef, it’s what for dinner.”
“Got Milk.”
“It’s not just for breakfast anymore.” (OJ)
[Milk: © Steven von Niederhausern / iStockphoto.com]

38. Advertising in Different Markets—2
Monopolistic competition
Advertising can increase demand for single firm’s product.
Gains from advertising go to the firm.
Want some pizza?
Lecture notes:
Now advertising is intended to increase the firm’s sales at the expense of its rival’s sales. If successful, the firm can recover its advertising costs with higher sales and markups.
[Papa Johns: Johnny Rockets/PRNewsFoto/AP Photo; Pizza Hut: © Steve Shepard/iStockphoto.com; Domino's: © Steve Shepard/iStockphoto.com]

39. Advertising in Different Markets—3
Monopoly
Advertising less likely since the product has no close substitutes and consumer choice is limited
May advertise simply to inform consumer about the product and stimulate demand
Lecture notes:
A monopoly in many cases would have no incentive to advertise.
Consumers have no alternative, so why promote your product?
Sometimes, a monopoly may try to increase demand just by letting “unaware” consumers know about the product.
Other times, it may just be a “reminder” of the product to stimulate demand.
Think about diamond commercials around Valentine’s Day.

40. Negative Effects of Advertising: Advertising and Costs
The paradox of advertising
Suppose Domino’s advertises.
All else equal, its sales will increase, and it will be able to recover its costs.
But, Papa John’s will respond with its own advertising campaign.
Net result: sales remain the same, but both firms have higher costs.
Negative business stealing externality
Lecture tip:
Ask students what the “paradox of advertising” is. There is a graphical analysis on next slide.

41. Advertising Increases Cost
Image: Animated Figure 12.6
Lecture notes:
First click:
Draws LRATC before advertising and profit-maximizing output and price.
Second click:
If there is no business-stealing effect, output increases from Q1 to Q2, and ATC falls.
Economies of scale effect outweighs higher ATC with advertising.
Third click:
Since rivals will also advertise, output remains at Q1.
The firm’s output does not change, but ATC is higher.

42. Negative Effects of Advertising
Inspires brand loyalty
More inelastic demand, which raises prices to consumers
Want to buy some pearls?
$43
$300
Lecture notes:
When people have strong preferences, they are willing to pay higher prices. Inelastic demand can increase prices.
[Pearls: © Atm2003 | Dreamstime.com; Tiffany: © Pedro Antonio Salaverría Calahorra | Dreamstime.com]

43. Economics in Mad Men, “Smoke Gets in Your Eyes”
“Everybody else’s tobacco is poisonous. Lucky Strike’s is toasted.”
“Economics in the Media” Slide
Lecture tip:
The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
This clip provides a good illustration of the negative effects of advertising. The key concepts covered in this clip are:
Product differentiation
Monopolistic competition
Oligopoly
Advertising

44. Negative Effects: Truth in Advertising
Advertising: Persuasive or informative?
Both, but advertising can be manipulative.
Firms may have an incentive to “lie.”
FTC regulates advertising
Enforces truth-in-advertising laws
Food, drugs, supplements, alcohol, and tobacco
Lecture notes:
Informative advertising: “Here is some information about our product.”
Persuasive advertising: “Here is why you should buy our product instead of a competitor’s product.”

45. Conclusion Monopolistic competition
Exists when many competing firms produce differentiated products
Has features of both perfect competition and monopoly
Is closer to perfect competition than monopoly in terms of prices, output, and efficiency
Is prevalent throughout our economy
Lecture notes:
We’ve now discussed three out of four market structures. The fourth market structure, oligopoly, will be discussed in the next chapter.
Here is a recap of some of the points made in this chapter:
Monopolistic competition is a market characterized by free entry and many firms selling differentiated products.
Differentiation by style or type, location, or quality
Monopolistic competitors are price makers.
P > MC, and produce with excess capacity.
Although inefficient, monopolistic competition is largely beneficial since firms produce a variety of goods.
In the long run, monopolistically competitive firms make zero positive economic profits.
Advertising performs useful functions.
Information, location, new products, and quality differences
However, advertising also increases costs and may be misleading.