Chapter 26

Chapter 25 Monopolistic Competition

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Introduction Why do so many rock bands today adopt names that involve odd combinations of everyday words? After all, what you care about is the quality of a band’s songs, its style, and the musical talents of the band members. To find out the answer to this question, you must learn about the market structure in which today’s rock bands interact, known as monopolistic competition.

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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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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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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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Did You Know That … • By the time Dan Brown’s novel The Lost Symbol, a sequel to The Da Vinci Code, appeared on retailers’ shelves, its price had fallen so much that retailers earned very few profits from selling the book? • Product heterogeneity and advertising did not show up in our analysis of perfect competition. • This instead is a situation of monopolistic competition—the subject of this chapter.

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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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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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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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Monopolistic Competition (cont'd) • Characteristics of monopolistic competition 1. Significant numbers 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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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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Monopolistic Competition (cont'd) • Product Differentiation – The distinguishing of products by brand name, color, and other minor attributes.

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Monopolistic Competition (cont'd) • Product differentiation and price – The firm has some control over the price it charges – Unlike a 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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Example: Is Punxsutawny Phil Hogging Too Much Attention? • Since 1887, Punxsutawny Phil, the groundhog residing in the Pennsylvania town of that name, has been used to predict the weather on February 2—the official Groundhog Day.

• Today, there are at least 17 “groundhog lodges” in Pennsylvania and nearby states, each of which promotes its own groundhog’s weatherforecasting talents in an effort to attract tourists to their communities.

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Monopolistic Competition (cont'd) • What do you think about advertising? – 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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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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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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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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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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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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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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Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (a)

• Price (P1) > ATC • Economic profit

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Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (b)

• Price (P1) < ATC • Economic loss

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Figure 25-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (c)

• Price (P1) = ATC • Normal rate of return

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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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Figure 25-2 Comparison of the Perfect Competitor with the Monopolistic Competitor

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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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

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Brand Names and Advertising • Because “differentness” has value for consumers, monopolistically competitive firms regard their brand names as valuable private (intellectual) property – Firms 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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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 25-1 Values of the Top Ten Brands

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Methods of Advertising • Direct Marketing – Advertising targeted at specific consumers: email, 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

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Figure 25-3 Distribution of U.S. Advertising Expenses

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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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Brand Names and Advertising • Examples of search goods – Clothing and music evaluated prior to purchase

• Examples of experience goods – Soft-drinks, restaurants, movies

• Examples of credence goods – Health care, legal advice

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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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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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Why Not … outlaw persuasive advertising? • Because the purpose of persuasive advertising is more to attract consumers’ attention and less to provide product information, many people think that persuasive advertising offers no clear benefits to society at large. • A company’s persuasive ads may demonstrate that it intends to expand its customer base and thereby perpetuates its operations for years to come. • In this way, even persuasive advertising offers some information to consumers. Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

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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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Information Products and Monopolistic Competition (cont'd)

• Information Product – An item that is produced using informationintensive inputs at a relatively high fixed cost but distributed for sale at a relatively low marginal cost

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Figure 25-4 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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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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Information Products and Monopolistic Competition (cont'd)

• Consider how 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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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 equal ATC; the firm earns sufficient revenues to cover total costs, including the opportunity cost of capital • Consumers thereby pay the lowest price necessary to induce sellers to provide the item Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

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Figure 25-5 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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You Are There: Stimulating Candy Sales by Adding Caffeine • Vroom Foods differentiates its “energy candy” products—Buzz Bites and Foosh Energy Mints—as “the most caffeinated products out there.” • Vroom’s competitors in the energy candy market include Crackheads, Extreme Sport Beans, Ice Breakers Energy Mints, and Snicker Charged candy bars. • In addition to including caffeine, Vroom is increasingly seeking to differentiate its energy candy products from the products of its competitors. Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

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Issues & Applications: Finding a Band Name Between ABBA and ZZ Top • The industry or rock music is monopolistically competitive as most bands seek to differentiate themselves by writing their own novel songs, and developing their own styles. • Another key product characteristic is a band’s name, as evidenced by names such as the Beatles, Grateful Dead, Led Zeppelin, Metallica, and Pink Floyd. • Thus, one of the first agenda items for a band after its formation is to find a unique name and obtain a legal trademark for it. Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

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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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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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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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Summary Discussion of Learning Objectives (cont'd) • Monopolistically competitive firms attempt to boost demand for their products through product differentiation – They engage heavily in advertising and marketing • Providing an information product entails incurring relatively high fixed costs but low marginal costs – In the long run equilibrium, price adjusts to equality with average total cost

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