1. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopolistic Competition Chapter 11

2. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure A distinguishing structural characteristic of monopolistic competition is that there are “many” firms in the industry. “Many” is somewhere between the “few” of oligopolies or the “hordes” that characterize perfect competition.

3. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure Monopolistic competition is a market in which many firms produce similar goods or services but each maintains some independent control of its own price.

4. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Low Concentration Low concentration ratios are common in monopolistic competition. –Concentration ratio – The proportion of total industry output produced by the largest firms (usually the four largest).

5. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Power Each producer in monopolistic competition is large enough to have some market power. –Market Power – The ability to alter the market price of a good or service.

6. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Power A monopolistically competitive firm confronts a downward-sloping demand curve for its output.

7. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Independent Production Decisions Modest changes in the output or price of any single firm will have no perceptible influence on the sales of any other firm.

8. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Independent Production Decisions The relative independence of monopolist competitors means that they don’t have to worry about retaliatory responses to every price or output change.

9. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Low Entry Barriers Another characteristic of monopolistic competition is the presence of low barriers to entry. –Barriers to entry – Obstacles that make it difficult or impossible for would-be producers to enter a particular market, such as patents.

10. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Behavior Monopolistic competition has distinctive behavior.

11. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Product Differentiation One of the most notable features of monopolistically competitive behavior is product differentiation. –Product differentiation - Features that make one product appear different from competing products in the same market.

12. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Brand Image Each firm has a distinct identity – a brand image. Consumers perceive its output to be somewhat different than others in the industry.

13. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Brand Loyalty By differentiating their products, monopolistic competitors establish brand loyalty. Brand loyalty gives producers greater control over the price of their products.

14. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Brand Loyalty Each firm only has a monopoly on its brand image. It still competes with other firms offering close substitutes.

15. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Brand Loyalty Brand loyalty makes the demand curve facing the firm less price-elastic. Brand loyalty implies that consumers shun substitute goods even when they are cheaper.

16. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Brand Loyalty Each monopolistically competitive firm will establish some consumer loyalty. A symptom of brand loyalty is the price differences between computers which are essentially the same.

17. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Price and Output The monopolistically competitive firm’s production decision is similar to that of a monopolist. –Production decision - The selection of the short-run rate of output (with existing plant and equipment).

18. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Price and Output As always, the profit-maximizing rate of output is achieved by producing the quantity where MR = MC.

19. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry and Exit With low barriers to entry, new firms will enter the market if there is economic profit. –Economic profit – The difference between total revenues and total economic costs.

20. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry and Exit When firms enter a monopolistically competitive industry: –The market supply curve shifts to the right. –The demand curves facing individual firms shift to the left.

21. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. No Long-Run Profits In the long run, there are no economic profits in monopolistic competition.

22. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Equilibrium in Monopolistic Competition Quantity(units per period) 0 ATC MC Price or Cost (dollars per unit) Initial demand The long run Price or Cost (dollars per unit) MR qaqa 0 papa F MC ATC Quantity (units per period) Demand K The short run caca Later MRqgqg pgpg G Later demand

23. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Effects of Entry on Industry and Firm Price (per unit) Quantity (units per time period) Market demand Initial market supply Effect of entry on the industry Price (per unit) Quantity (units per time period) Initial demand facing firm Effect of entry on the monopolistically competitive firm New entry Later market supply Reduced market share Later demand facing film MR p1p1 p2p2

24. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Inefficiency Monopolistic competition tends to be less efficient in the long run than a perfectly competitive industry.

25. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Capacity Because of the industry-wide excess capacity, each firm produces a rate of output that is less than its minimum ATC. Thus, the same level of industry output could be produced at lower cost with fewer firms.

26. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Flawed Price Signals The monopolistically competitive firm will always price its output above the level of marginal cost.

27. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Flawed Price Signals Monopolistic competition results in both production inefficiency (above-minimum average cost) and allocative inefficiency (wrong mix of output).

28. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. No Cease-Fire in Advertising Wars In truly (perfectly) competitive industries, firms compete on the basis of price. Imperfectly competitive firms engage in nonprice competition – the most prominent form being advertising.

29. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. No Cease-Fire in Advertising Wars Advertising may be more responsible for brand loyalty than the taste of the product. Having a recognizable name is worth billions in sales.

30. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopolistic Competition End of Chapter 11