Transcript Chapter 26 - The Citadel

Chapter 26
Monopolistic
Competition
Introduction
The typical consumers of “toy trains” are
not children.
In order to appeal to the adult consumers,
producers differentiate their trains by making
them look realistic.
Recently, real-world rail transport companies have
pushed up the cost of product differentiation.
Producers pay license fees to real-world
transport companies to use their logos, which
affect prices and output in a monopolistically
competitive market.
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26-2
Learning Objectives
• Discuss the key characteristics of a
monopolistically competitive industry
• Contrast the output and pricing decisions of
monopolistically competitive firms with those
of perfectly competitive firms
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26-3
Learning Objectives (cont'd)
• Explain why brand names and advertising
are important features of monopolistically
competitive industries
• Describe the fundamental properties of
information products and evaluate how the
prices of these products are determined
under monopolistic competition
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26-4
Chapter Outline
• Monopolistic Competition
• Price and Output for the
Monopolistic Competitor
• Comparing Perfect Competition
with Monopolistic Competition
• Brand Names and Advertising
• Information Products and
Monopolistic Competition
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26-5
Did You Know That…
• Since 2004, annual spending on new
building construction at U.S. colleges
and universities has exceeded $14
billion per year?
• Most of the expenditures have financed
student centers with various amenities
that individual universities hope will
help their schools stand out?
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26-6
Did You Know That… (cont'd)
• Advertising plays a large role in industries
that cannot be described as perfectly
competitive but cannot be described as pure
monopolies either?
• Consumers’ preferences for variety and
competition among producers has led to
similar but differentiated products in the
marketplace. This situation has been
described as monopolistic competition.
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26-7
Monopolistic Competition
• In the 1920s and 1930s, economists
were aware of industries that did
not fit under perfect competition or
pure monopoly.
• Theoretical and empirical research
was instituted to develop some sort
of middle ground.
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26-8
Monopolistic Competition (cont'd)
• Two separately developed models of
monopolistic competition resulted.
• At Harvard, Edward Chamberlin published
Theory of Monopolistic Competition in 1933.
• That same year, Joan Robinson of
Cambridge published The Economics of
Imperfect Competition.
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26-9
Monopolistic Competition (cont'd)
• Monopolistic Competition
 A market situation in which a large
number of firms produce similar but
not identical products
 Entry into the industry is relatively easy.
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26-10
Monopolistic Competition (cont'd)
• Characteristics of
monopolistic competition
1. Significant number of sellers in a highly
competitive market
2. Differentiated products
3. Sales promotion and advertising
4. Easy entry of new firms in the long run
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26-11
Monopolistic Competition (cont'd)
• Implications of the large number
of firms
1. Small market share
2. Lack of collusion
3. Independence
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26-12
Monopolistic Competition (cont'd)
• Product Differentiation
 The distinguishing of products by brand
name, color, and other minor attributes
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26-13
Monopolistic Competition (cont'd)
• Product differentiation and price
 Firm has some control over the price it charges.
 Unlike perfect competitor, it faces a downward
sloping demand curve.
 Consider the abundance of brand names for
many products.

The more successful the firm is at differentiation, the
more control it has over price.
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26-14
Example: What Else Besides a Tart
Taste do Cranberries Have to Offer?
• Making cranberries taste like other fruits and
berries presented cranberry producers the
problem of how to differentiate their product.
• Producers have promoted taste and the
healthful properties of cranberry juice.
• Sellers emphasize the distinctive experience
associated with eating the fruit and its
curative properties.
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26-15
Monopolistic Competition (cont'd)
• What do you think?
 Would a perfect competitor have any
incentive to advertise?
 Why would a monopolistically competitive
firm advertise?
 Can advertising lead to efficiency?
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26-16
Monopolistic Competition (cont'd)
• Sales promotion and advertising
 Can increase demand for a firm
 Can differentiate a firm’s product
 Can result in increased profits
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26-17
Monopolistic Competition (cont'd)
• Question
 How much advertising should
be undertaken?
• Answer
 It should be carried to the point at which
the additional revenue from one more
dollar of advertising just equals that one
dollar of additional cost.
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26-18
Monopolistic Competition (cont'd)
• Ease of entry
 For any current monopolistic competitor,
potential competition is always lurking in
the background.
 The easier—that is, the less costly—entry
is, the more a current competitor must
worry about losing business.
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26-19
Price and Output for the
Monopolistic Competitor
• The individual firm’s demand and
cost curves
 Demand curve slopes downward
 Profit maximized where MC intersects MR
from below
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26-20
Price and Output for the
Monopolistic Competitor (cont'd)
• Short-run equilibrium
 In the short run, it is possible for a
monopolistic competitor to make economic
profits—profits over and above the normal
rate of return, or beyond what is necessary
to keep that firm in the industry.
 Losses in the short run are clearly
also possible.
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26-21
Price and Output for the
Monopolistic Competitor (cont'd)
• The long run: zero economic profits
 The rate of return will tend toward normal.
 Economic profits will tend toward zero.
 So many firms produce substitutes,
any economic profits will disappear
with competition.
 Reduced to zero either through entry of new
firms seeking to earn a higher rate or return, or
by changes in product quality and advertising
outlays by existing firms
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26-22
Figure 26-1 Short-Run
and Long-Run Equilibrium with
Monopolistic Competition, Panel (a)
• Price (P1) > ATC
• Economic profit
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26-23
Figure 26-1 Short-Run
and Long-Run Equilibrium with
Monopolistic Competition, Panel (b)
• Price (P1) < ATC
• Economic loss
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26-24
Figure 26-1 Short-Run
and Long-Run Equilibrium with
Monopolistic Competition, Panel (c)
• Price (P1) = ATC
• Normal rate of return
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26-25
Comparing Perfect Competition with
Monopolistic Competition
• Question
 If both a monopolistic and perfect
competitor make zero economic profit in
the long run, how are they different?
• Answer
 Demand curve for individual perfect
competitor is perfectly elastic.
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26-26
Figure 26-2
Comparison of the Perfect Competitor
with the Monopolistic Competitor
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26-27
Comparing Perfect Competition with
Monopolistic Competition (cont'd)
• In perfect competition, the long-run equilibrium
occurs where average total cost is minimized (this
does not occur in monopolistic competition).
• Some have argued that this is not necessarily a
waste of resources—as the added cost arises from
product differentiation.
• Chamberlin argued it is rational for consumers to
have a taste for differentiation; consumers willingly
accept the resultant increased production costs in
return for more choice and variety of output.
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26-28
Brand Names and Advertising
• Because “differentness” has value for
consumers, monopolistically competitive
firms regard their brand names as valuable
private (intellectual) property.
 Use trademarks, words, symbols, and logos to
distinguish their product brands from goods or
services sold by other firms

A successful brand image contributes to a
firm’s profitability.
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26-29
Brand Names
and Advertising (cont'd)
• Brand names and trademarks
 A company’s value in the marketplace
depends largely on current perceptions of
future profitability.
 We can see it in the market value of the
world’s most valuable product brands.
 Valuation depends on the market prices of
shares of stock of a company times the
number of shares traded.
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Table 26-1
Values of the Top Ten Brands
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Methods of Advertising
• Direct Marketing
 Advertising targeted at specific consumers:
e-mail, regular mail
• Mass Marketing
 Advertising intended to reach as many customers
as possible: radio, TV, newspaper
• Interactive Marketing
 Permits consumer to follow up directly by
searching for more information
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26-32
Figure 26-3 Distribution of U.S.
Advertising Expenses
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26-33
Informational Versus
Persuasive Advertising
• Search Good
 A product with characteristics that enable an
individual to evaluate the product’s quality in
advance of a purchase
• Experience Good
 A product that an individual must consume before
the product’s quality can be established
• Credence Good
 A product with qualities that consumers lack the
expertise to assess without assistance
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26-34
Brand Names and Advertising
• Search goods
 Clothing and music evaluated prior
to purchase
• Experience goods
 Soft-drinks, restaurants, movies
• Credence goods
 Health care, legal advice
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26-35
Brand Names
and Advertising (cont'd)
• Informational Advertising
 Advertising that emphasizes transmitting
knowledge about the features of a product
• Persuasive Advertising
 Advertising that is intended to induce a
consumer to purchase a particular product
and discover a previously unknown taste
for an item
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26-36
Brand Names
and Advertising (cont'd)
• Advertising as a signaling behavior
 Individual companies can explicitly engage
in signaling behavior.
 They do so by establishing brand names
or trademarks and promoting them.
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26-37
Information Products and
Monopolistic Competition
• Information products, such as
computer operating systems, software,
and digital music and videos, have a
unique cost structure.
• Product development entails high
fixed costs, but the marginal cost of
producing a copy for one more
customer is low.
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26-38
Information Products and
Monopolistic Competition (cont'd)
• Information Product
 An item that is produced using information-
intensive inputs at a relatively high fixed
cost but distributed for sale at a relatively
low marginal cost
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26-39
Figure 26-4 Cost Curves for a
Producer of an Information Product
• TFC is $250,000
• Producer sells 5,000 copies
AFC falls to $50 per copy
• What is AFC if producer sells
50,000 copies?
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26-40
Information Products and
Monopolistic Competition (cont'd)
• Short-Run Economies of Operation
 A distinguishing characteristic of an
information product arising from declining
short-run average total cost as more units
of the product are sold
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26-41
Information Products and
Monopolistic Competition (cont'd)
• Computer game manufacturers
operate in a monopolistically
competitive market.
• In monopolistic competition, marginal
cost pricing results in losses for the
firm, even though it creates efficiencies
for the economy as a whole.
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26-42
Figure 26-5 The Infeasibility of Marginal
Cost Pricing of an Information Product
Firm cannot behave
as if it were a perfect
competitor setting
price at $2.50
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26-43
Information Products and
Monopolistic Competition (cont'd)
• Providing an information product entails incurring
relatively high fixed costs, but a relatively low per-unit
cost for additional units of output.
• The ATC for a firm that sells an information product
slopes downward, meaning the firm experiences
short-run economies of operation.
• In a long-run monopolistically competitive
equilibrium, price adjusts to equality with ATC; the
firm earns sufficient revenues to cover total costs,
including the opportunity cost of capital.
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26-44
Issues and Applications: Paying for the
Right to Produce Realistic Model Trains
• A toy hobby meets trademark protection.
• In model railroading, product differentiation
now has a price.
• Why might those old trademarks be
worth something?
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26-45
Summary Discussion
of Learning Objectives
• Key characteristics of a monopolistically
competitive industry
 Large number of small firms
 Differentiated products
 Easy entry and exit
 Advertising and sales promotion
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26-46
Summary Discussion
of Learning Objectives (cont'd)
• Contrasting the output and pricing decisions
of monopolistically competitive firms with
those of perfectly competitive firms
 Monopolistically competitive firm in short run

Produces output to point MR = MC in short run

Price set on demand curve, can be less than MC and
ATC in short run, firm earns economic profits
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26-47
Summary Discussion
of Learning Objectives (cont'd)
• Contrasting the output and pricing decisions
of monopolistically competitive firms with
those of perfectly competitive firms
 Monopolistically competitive firm in the long run

Price = ATC in the long run as firms enter industry

Like perfectly competitive firms, earns zero economic
profits in long run

Price exceeds MC in long run
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26-48
Summary Discussion
of Learning Objectives (cont'd)
• Monopolistically competitive firms
attempt to boost demand for their
products through product differentiation.
• Providing an information product entails
incurring relatively high fixed costs but
low marginal costs.
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26-49
End of
Chapter 26
Monopolistic
Competition