Monolistic Competition

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PowerPoint Slides prepared by: V. Andreea CHIRITESCU Eastern Illinois University

N. GREGORY MANKIW

PRINCIPLES OF

ECONOMICS Eight Edition

Monopolistic Competition

CHAPTER

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Monopolistic Competition •  Imperfect competition

– Between perfect competition and monopoly

– Oligopoly – Monopolistic competition

•  Oligopoly – Few sellers – Offer similar or identical products

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Monopolistic Competition •  Concentration ratio

– Percentage of total output in the market supplied by the four largest firms

•  Oligopolies, highly-concentrated industries (concentration ratio %) – Major household appliances (90%) – Tires (91%), Light bulbs (92%) – Soda (94%) – Wireless telecommunications (95%)

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Monopolistic Competition •  Monopolistic competition

– Many sellers – Product differentiation

•  Not price takers •  Downward sloping demand curve

– Free entry and exit •  Zero economic profit in the long run

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Figure 1 The Four Types of Market Structure

Economists who study industrial organization divide markets into four types—monopoly, oligopoly, monopolistic competition, and perfect competition.

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Short Run Equilibrium

•  Profit maximization – Produce the quantity where marginal

revenue = marginal cost – Price: on the demand curve – If P > ATC: profit – If P < ATC: loss – Similar to monopoly

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Figure 2 Monopolistic Competitors in the Short Run

Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal revenue equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is greater than average total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost.

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Price

Quantity 0

(a) Firm makes profit

Profit

ATC

Profit-maximizing quantity

(b) Firm makes losses

Demand

Price

Quantity 0

Losses

MC ATC

Loss-minimizing quantity

ATC

Demand

Price ATC

Long Run Equilibrium

•  If firms are making profit in short run – New firms - incentive to enter the market – Increase number of products – Reduces demand faced by each firm

•  Demand curve shifts left – Each firm’s profit declines until: zero

economic profit

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Figure 3 A Monopolistic Competitor in Long Run

In a monopolistically competitive market, if firms are making profits, new firms enter, causing the demand curves for the incumbent firms to shift to the left. Similarly, if firms are making losses, some of the firms in the market exit, causing the demand curves of the remaining firms to shift to the right. Because of these shifts in demand, monopolistically competitive firms eventually find themselves in the long-run equilibrium shown here. In this long-run equilibrium, price equals average total cost, and each firm earns zero profit.

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Price

Quantity 0

MC ATC

Profit- maximizing quantity

MR Demand

Price = ATC

Long Run Equilibrium

•  Zero economic profit – Demand curve

•  Tangent to average total cost curve •  At quantity where marginal revenue =

marginal cost – Price = average total cost – Price exceeds marginal cost

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Long Run Equilibrium

•  Monopolistic versus perfect competition – Monopolistic competition

•  Quantity: not at minimum ATC (excess capacity)

•  P > MC, markup over marginal cost – Perfect competition

•  Quantity: at minimum ATC (efficient scale) •  P = MC

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Figure 4 Monopolistic versus Perfect Competition

Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-run equilibrium in a perfectly competitive market. Two differences are notable. (1) The perfectly competitive firm produces at the efficient scale, where average total cost is minimized. By contrast, the monopolistically competitive firm produces at less than the efficient scale. (2) Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition.

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Price

Quantity 0

(a) Monopolistically Competitive Firm

ATC

Quantity produced

(b) Perfectly Competitive Firm

Demand

Price

Quantity 0 Efficient scale

Markup

MC ATC

Quantity produced = Efficient scale

P=MR (demand curve)

P=MC

Excess capacity

Welfare of Society

•  Sources of inefficiency – Markup of price over marginal cost

•  Deadweight loss of monopoly pricing – Too much or too little entry

•  Product-variety externality (positive externality on consumers)

•  Business-stealing externality (negative externality on existing firms)

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Advertising

•  Incentive to advertise – When firms sell differentiated products

and charge prices above marginal cost – Advertise to attract more buyers

•  Advertising spending – Highly differentiated goods: 10-20% of

revenue – Industrial products: Little advertising – Homogenous products: No advertising

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Advertising

•  Debate over advertising – Wasting resources? – Valuable purpose?

•  The critique of advertising – Firms advertise to manipulate people’s

tastes •  Psychological rather than informational •  Creates a desire that otherwise might not

exist

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Advertising

•  The critique of advertising – Impedes competition – Increase perception of product

differentiation •  Foster brand loyalty

– Makes buyers less concerned with price differences among similar goods

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Advertising

•  The defense of advertising – Provide information to customers

•  Customers - make better choices •  Enhances the ability of markets to allocate

resources efficiently – Fosters competition

•  Customers - take advantage of price differences

– Allows new firms to enter more easily

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Advertising and the price of eyeglasses

•  What effect does advertising have on the price of a good? – Consumers – view products as being

more different than they otherwise would •  Markets less competitive •  Firms’ demand curves less elastic •  Higher prices

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Advertising and the price of eyeglasses

•  What effect does advertising have on the price of a good? – Consumers – easier to find firms with the

best prices •  Markets – more competitive •  Firms’ demand curves more elastic •  Lower prices

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Advertising and the price of eyeglasses

•  1972, economist Lee Benham •  States that prohibited advertising

– Average price = $33 ($248 in 2012 dollars)

•  States that did not restrict advertising – Average price = $26 ($196 in 2012

dollars) •  Advertising

– Reduced average prices – Fosters competition

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Advertising

•  Advertising as a signal of quality – Little apparent information – Real information offered – a

signal •  Willingness to spend large amount of money •  = signal about quality of the

product – Content of advertising =

irrelevant 21

Is it rational for consumers to be impressed that Jennifer Aniston is endorsing this product?

Advertising

•  Brand names – Spend more on advertising and charge

higher prices than generic substitutes

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Advertising

•  Critics of brand names – Products – not differentiated – Irrationality: consumers are willing to pay

more for brand names •  Defenders of brand names

– Consumers – information about quality – Firms – incentive to maintain high quality

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Table 1 Monopolistic Competition: Between Perfect Competition and Monopoly

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