Monopolistic Competition Chapter 11

1. Monopolistic CompetitionChapter 11 Definitions and Descriptions of Monopolistic Competition Product Differentiation Identifying the Monopolistic Competitor Profit Maximization in Short-Run and Long-Run Price Discrimination Efficiency or Inefficiency Closing Thoughts

2. Monopolistic Competition On one extreme is the Perfect Competition model On the other extreme is the Monopoly Model Monopolistic Competition & Oligopoly are competitive scenarios that lie between these two extremes Therefore, competitive features of Monopolistic Competition and Oligopoly will emulate either Perfect Competition or Monopoly 1

3. Characteristics of Monopolistic Competition Power to set prices somewhat like a monopoly Face competition like perfect competition ********************************************* Large number of firms -- Each firm has relatively small market share -- Each firm must be sensitive to average market price of its product -- Collusion is not possible due to the number of firms No barriers to entry or exit 2

4. Characteristics of Monopolistic Competition Product Differentiation � Each firm makes a product that is slightly different from the products of competing firms. -- Close substitutes but no perfect substitutes -- An attempt to increase price will normally results in a lower volume sold Competition on Quality, Price, Marketing -- Quality is design, reliability, service provided to buyer and ease of access to product -- Price � downward sloping demand curve -- Marketing � firm must market = promotion, distribution, packaging 3

5. Product Differentiation Product differentiation is crucial to monopolistic competition People value variety, even if it is not material (real) Product differentiation takes place in buyer�s mind Americans are provided with a wide variety of products and services Variety is valued but costly � we pay for it

6. The Typical Monopolistic Competitor The monopolistic competitor tries to set his or her product apart from the competition The main way of doing this is through advertising When this is done successfully, the demand curve becomes more vertical or inelastic Buyers are willing to pay more for a product or service because they believe it is much better than their other choices

7. Basis for Product Differentiation Physical differences Convenience Ambience Reputations Appeals to vanity Unconscious fears and desires Snob appeal Customized products

8. Product Differences Product differentiation does not necessarily mean there are any physical differences among products They might all be the same, but how they are sold may make all the difference There are, of course, some very real physical product differences. Buyers often differentiate based on real physical differences, but differentiation is still taking place in the buyers mind, and it may or may not be based on real physical differences

9. Advertising and Branding What�s to be gained by pouring money into advertising? It works! -- Continuous signals regarding product differentiation -- coca-cola vs pepsi Brand has tremendous value -- e.g. Budweiser -- Brands tend to capture in a single name all the values a firm wants to impress upon the buyer

10. The Typical Monopolistic Competitor Tries to set his firm apart from his competition -- New Product Development and Innovation 1. Striving to maintain an economic profit -- Advertising 1. Create consumer perception of product differentiation � real or imagined 2. Attempting to keep demand as inelastic as possible Selling costs can be extremely high

11. Identifying Monopolistic Competition How much is the industry dominated or not dominated by few suppliers -- geographical scope � national, regional, global An industry can be almost perfectly competitive on a national scope, but almost a monopoly locally e.g. Concrete Mixing -- Barriers to entry and exit � industries may appear concentrated but few barriers exist to prevent entry: e.g a community with only one restaurant- there is no barrier to other restaurants coming in 4

12. Identifying Monopolistic Competition The four-firm concentration ratio � The percentage of the value of total market revenue accounted for by the four largest firms in the industry -- A low concentration ratio indicates a high degree of competition -- A high concentration ratio indicates an absence of competition 5

13. Identifying Monopolistic Competition The Herfindahl-Hirschman Index � the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50) -- In perfect competition, the HHI is small -- In monopoly, the HHI is 10,000 (100 squared) -- A popular measure with the Justice Dept in the 1980�s HHI < 1000 characterized competitive markets HHI > 1800 would bring Justice Dept challenge to proposed mergers 6

14. Examples of Monopolistic Competition Banks Sporting Goods Radio Stations Fish and Seafood Clothing Jewelry Computers Health Spas Frozen Foods Apparel Stores Canned Goods Convenience Stores 7

15. Monopolistic Competition Since the Monopolistic Competitor prices at demand where MR=MC, the firm may have 1. excess production capacity, and is 2. operating below its efficient scale where ATC is minimum Markup � The amount by which price exceeds MC

16. The Monopolistic Competitor in the Short Run The monopolistic competitor can make a profit or take a loss As only one firm in a crowded industry it has a very elastic demand curve No one firm can get too far out of line on price because buyers can always purchase a substitute from some one else

20. Price Discrimination Question � Does price discrimination raise or lower profit? Price discrimination � selling the same good or service at a number of different prices. Basically an illegal activity under the Clayton Act unless there is a cost justification for the price discrimination Answer � Price discrimination is a marketing means to increase economic profit

21. Price Discrimination Methods of price discrimination -- Discriminate among groups of buyers works when different buying groups are willing to pay different prices (on the average) for the same good or service Example: Airline travel � prices target business travelers vs leisure time travelers -- discriminator is advance notice, shorter the notice, the higher the price

22. Some Examples of Price Discrimination Doctors often charge rich patients more than poor patients They may have one price for those with insurance and another price for those without insurance Movies in the evening cost more than those in the early afternoon Senior citizen, youth, and student discounts New and used cars Youth fairs on airlines Evening meals in restaurants often cost more than the same meal at lunch

23. Practicing Price Discrimination The firm that practices price discrimination must be able to distinguish between two or more separate groups of buyers Price discriminators must also be able to prevent buyers from reselling the product or service For example, if a fifteen-year-old could resell his youth fare seat to an adult who could then use it, the price discrimination effort would fail

24. Motives for Price Discrimination In most cases, price discrimination is basically a mechanism for rationing goods and services The main motivation for price discrimination is to raise profits The greater the price discrimination, the greater the profits because buyers lose some of their �consumer surplus� If price discrimination were carried to its logical conclusion, we would have perfect price discrimination The buyers would lose all of their �consumer surplus�

25. Price Discrimination Methods of discrimination -- Discriminate among units � firm charges the same price to all customers but there are volume discounts The key idea is to figure a way to charge those incremental buyers who are willing to pay more a higher price Result � Consumer Surplus is converted to Producer Surplus

26. Price Discrimination Perfect Price discrimination occurs when a firm figures out how to extract the entire consumer surplus (page 357) Once the firm has the entire consumer surplus, the MR curve becomes the Demand Curve At that point, the firm extracts even more economic profit by increasing production to the point where MR(D) = MC (page 357)

27. Price Discrimination Efficiency � When the firm increases output to the point where MC = D, the efficient quantity is produced, but The producer has taken all the consumer surplus, and Since there is ample economic profit, the firm may be induced to spend money (increase costs) to protect its economic profit (rent seeking and is usually political in nature)

28. Is the Monopolistic Competitor Inefficient? From a purely economic standpoint . . .Yes! The firms do not produce at the minimum point on the ATC There may be too many firms in most industries Are there too many beauty parlors? Not if you want to get your hair done on Friday afternoon or Saturday morning Are there too many restaurants? Not on Sunday There may be overdifferentiation Would Americans want the drab businesses that characterize eastern Europe and the old soviet union? Would Americans want only one brand of toothpaste or one brand and model of a car? In America, it would be hard to imagine a no-frills world

29. Closing Thoughts More than 99% of the over 23 million business firms in the United States are monopolistic competitors While price competition exists, they compete more vigorously over differentiation characteristics such as ambience, service, convenience, quality, brand awareness, etc.