Chapter
16
Monopolistic Competition
Between Monopoly & Perfect Competition
Imperfect competition
Between perfect competition and monopoly Oligopoly Monopolistic competition
Oligopoly
Few sellers Offer similar or identical products
Between Monopoly & Perfect 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
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.
Competition with Differentiated Products
Monopolistically competitive firm in short run Profit maximization
Quantity: marginal revenue = marginal cost Price: on the demand curve If P > ATC: profit If P < ATC: loss
Figure 2 Monopolistic competitors in the short run
(a) Firm makes profit Price MC Price MC ATC Price Profit Demand Losses Demand ATC (b) Firm makes losses
Price
ATC
ATC
MR
0 Profitmaximizing quantity Quantity 0 Lossminimizing quantity
MR Quantity
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 above average total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost. 6
Competition with Differentiated Products
The 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 firms profit declines until: zero economic profit
7
Competition with Differentiated Products
The long run equilibrium If firms are making losses in short run
Firms - incentive to exit the market Decrease number of products Increases demand faced by each firm
Demand curve shifts right
Each firms loss declines until: zero economic profit
8
Figure 3 A monopolistic competitor in the long run
Price MC ATC
Price = ATC
MR 0 Profit- maximizing quantity
Demand Quantity
In a monopolistically competitive market, if firms are making profit, new firms enter, and the demand curves for the incumbent firms shift to the left. Similarly, if firms are making losses, old firms exit, and the demand curves of the remaining firms shift to the right. Because of these shifts in demand, a monopolistically competitive firm eventually finds itself in the long-run equilibrium shown here. In this long-run equilibrium, price equals average total cost, and the 9 firm earns zero profit.
Competition with Differentiated Products
The 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
10
Competition with Differentiated Products
Monopolistic versus perfect competition, long run equilibrium
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
11
Figure 4 Monopolistic versus perfect competition
(a) Monopolistically Competitive Firm
Price MC ATC P=MC Markup MC Demand MR 0 Quantity produced Efficient scale Quantity 0 Quantity produced = Efficient scale P=MR (demand curve) Price MC ATC Price
(b) Perfectly Competitive Firm
Quantity
Excess capacity Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the longrun 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, 12 but price is above marginal cost under monopolistic competition.
Competition with Differentiated Products
Monopolistic competition & societys welfare Sources of inefficiency
Markup of price over marginal cost
Deadweight loss
Too much or too little entry
Product-variety externality
Positive externality on consumers
Business-stealing externality
Negative externality on producers
13
Advertising
When firms
Sell differentiated products At price above marginal cost
Then, they have incentive to advertise
To attract more buyers
14
Advertising
Debate over advertising The critique of advertising
Firms advertise to manipulate peoples tastes
Psychological rather than informational Creates a desire that otherwise might not exist
Impedes competition Increase perception of product differentiation
Foster brand loyalty
Makes buyers less concerned with price differences among similar goods
15
Advertising
Debate over 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
16
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
Consumers easier to find firms with the best prices
Markets more competitive Firms demand curves more elastic Lower prices
17
Advertising and the price of eyeglasses 1963, Test: advertising by optometrists States that prohibited advertising
Average price paid for a pair of eyeglasses = $33
States that did not restrict advertising
Average price = $26
Advertising
Reduced average prices Fosters competition
18
Advertising
Advertising as a signal of quality Advertising 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
19
Advertising
Brand names Firm brand name
Spend more on advertising Charge higher prices Than generic substitutes
Critics of brand names
Products not differentiated Irrationality: consumers are willing to pay more for brand names
20
Advertising
Brand names Defenders of brand names
Useful: high quality
Consumers information about quality Firms incentive to maintain high quality
21
Table
1
Market structure Perfect competition Monopolistic competition Monopoly
Monopolistic competition: between perfect competition& monopoly
Features that all three market structures share Goal of firms Rule for maximizing Can earn economic profits in the short run? Features that monopolistic competition shares with monopoly Price taker? Price Produces welfare-maximizing level of output? Features that monopolistic competition shares with competition Number of firms Entry in long run? Can earn economic profits in long run?
Maximize profits MR = MC
Maximize profits MR = MC
Maximize profits MR = MC
Yes
Yes
Yes
Yes P = MC
No P > MC
No P > MC
Yes
No
No
Many Yes
Many Yes
One No
No
No
Yes
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