1. Copyright © 2006 Pearson Education Canada Monopolistic Competition and Oligopoly 14 & 15 CHAPTER

2. Copyright © 2006 Pearson Education Canada Searching the Globe for a Niche Globalization brings enormous diversity in products and thousands of firms seek to make their own product special and different from the rest of the pack. Two firms produce the chips that drive most PCs. Firms in these markets are neither price takers like those in perfect competition nor are they protected from competition by barriers to entry like a monopoly. How do such firms choose the quantity to produce and price?

3. Copyright © 2006 Pearson Education Canada Monopolistic Competition Monopolistic competition is a market structure in which  A large number of firms compete.  Each firm produces a differentiated product.  Firms compete on product quality, price, and marketing.  Firms are free to enter and exit the industry.

4. Copyright © 2006 Pearson Education Canada Monopolistic Competition Large Number of Firms The presence of a large number of firms in the market implies:  Each firm has only a small market share and therefore has limited market power to influence the price of its product.  Each firm is sensitive to the average market price but no firm pays attention to the actions of others. So no one firm’s actions directly affect the actions of other firms.  Collusion, or conspiring to fix prices, is impossible.

5. Copyright © 2006 Pearson Education Canada Monopolistic Competition Product Differentiation A firm in monopolistic competition practises product differentiation if the firm makes a product that is slightly different from the products of competing firms.

6. Copyright © 2006 Pearson Education Canada Monopolistic Competition Competing on Quality, Price, and Marketing Product differentiation enables firms to compete in three areas: quality, price, and marketing. Quality includes design, reliability, and service. Because firms produce differentiated products, the demand for each firm’s product is downward sloping. But there is a tradeoff between price and quality. Because products are differentiated, a firm must market its product. Marketing takes the two main forms: advertising and packaging.

7. Copyright © 2006 Pearson Education Canada Monopolistic Competition Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot make an economic profit in the long run. Examples of Monopolistic Competition Figure 13.1 on the next slide shows market share of the largest firms and the HHI for each of ten industries that operate in monopolistic competition.

8. Copyright © 2006 Pearson Education Canada Monopolistic Competition The red bars refer to the 4 largest firms. Blue is the next 4 largest. Orange is the next 12 largest. The numbers are the HHI.

9. Copyright © 2006 Pearson Education Canada Price and Output Monopolistic Competition The Firm’s Short-Run Output and Price Decision A firm that has decided the quality of its product and its marketing program produces the profit-maximizing quantity at which its marginal revenue equals its marginal cost (MR = MC). Price is determined from the demand curve for the firm’s product and is the highest price that the firm can charge for the profit-maximizing quantity. Figure 13.2 on the next slide shows a short-run equilibrium for a firm in monopolistic competition.

10. Copyright © 2006 Pearson Education Canada Price and Output in Monopolistic Competition The firm in monopolistic competition operates much like a single-price monopoly. The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price. It earns an economic profit (as in this example) when P > ATC.

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12. Price and Output in Monopolistic Competition Profit Maximizing Might be Loss Minimizing A firm might incur an economic loss in the short run. Here is an example. At the profit-maximizing quantity, P < ATC and the firm incurs an economic loss.

13. Copyright © 2006 Pearson Education Canada Price and Output in Monopolistic Competition Long Run: Zero Economic Profit In the long run, economic profit induces entry. And entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC). In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC.

14. Copyright © 2006 Pearson Education Canada Price and Output in Monopolistic Competition As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward. The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity. Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit.

15. Copyright © 2006 Pearson Education Canada Price and Output in Monopolistic Competition Figure 13.4 shows a firm in monopolistic competition in long-run equilibrium. If firms incur an economic loss, firms exit to achieve the long-run equilibrium.

16. Copyright © 2006 Pearson Education Canada Product Development and Marketing Innovation and Product Development We’ve looked at a firm’s profit-maximizing output decision in the short run and in the long run, for a given product and with given marketing effort. To keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development. New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation.

17. Copyright © 2006 Pearson Education Canada Product Development and Marketing Innovation is costly, but it increases total revenue. Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation. Production development may benefit the consumer by providing an improved product, or it may only the appearance of a change in product quality. Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which is the amount the consumer is willing to pay for it.

18. Copyright © 2006 Pearson Education Canada Product Development and Marketing Advertising Firms in monopolistic competition incur heavy advertising expenditures. Figure 13.6 shows advertising expenditure as a percentage of the total price in some industries. Cleaning supplies and toys top the list at almost 15 percent.

19. Copyright © 2006 Pearson Education Canada Product Development and Marketing Selling Costs and Total Costs Selling costs, like advertising expenditures, fancy retail buildings, etc. are fixed costs. Average fixed costs decrease as production increases, so selling costs increase average total costs at any given level of output but do not affect the marginal cost of production. Selling efforts such as advertising are successful if they increase the demand for the firm’s product.

20. Copyright © 2006 Pearson Education Canada Product Development and Marketing Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced. Here, with no advertising, the firm produces 25 units of output at an average total cost of $60.

21. Copyright © 2006 Pearson Education Canada What is Oligopoly? Small Number of Firms Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate. Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions. Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit. Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.

22. Copyright © 2006 Pearson Education Canada What is Oligopoly? Examples of Oligopoly Figure 13.10 shows some examples of oligopoly. An HHI that exceeds 1800 is generally regarded as an oligopoly. An HHI below 1800 is generally regarded as monopolistic competition.

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24. Two Traditional Oligopoly Models I) The Kinked Demand Curve Model In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.

25. Copyright © 2006 Pearson Education Canada Two Traditional Oligopoly Models Figure 13.11 shows the kinked demand curve model. The demand curve that a firm believes it faces has a kink at the current price and quantity.

26. Copyright © 2006 Pearson Education Canada Two Traditional Oligopoly Models Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.

27. Copyright © 2006 Pearson Education Canada Two Traditional Oligopoly Models The kink in the demand curve means that the MR curve is discontinuous at the current quantity— shown by that gap AB in the figure.

28. Copyright © 2006 Pearson Education Canada Two Traditional Oligopoly Models This slide helps to envisage why the kink in the demand curve puts a break in the marginal revenue curve.

29. Copyright © 2006 Pearson Education Canada Two Traditional Oligopoly Models Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit- maximizing quantity and price unchanged. For example, if costs increased so that the MC curve shifted upward from MC 0 to MC 1, the profit- maximizing price and quantity would not change.

30. Copyright © 2006 Pearson Education Canada Two Traditional Oligopoly Models The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact If MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesn’t maximize profit.

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32. Two Traditional Oligopoly Models II) Dominant Firm Oligopoly In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. The large firm operates as a monopoly, setting its price and output to maximize its profit. The small firms act as perfect competitors, taking as given the market price set by the dominant firm.

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