Firms face low entry barriers Differentiated Products - they face a downward sloping demand curve

1. Monopolistic Competition • Firms face low entry barriers • Differentiated Products • -they face a downward sloping demand curve • -no Long Run Profits • -Non-price Competition • Price Taker • Many Small Firms

2. Product Differentiation • Price-searchers producedifferentiated products – products that differ in design, dependability, location, ease of purchase, etc. • Rival firms produce similar products (good substitutes) and therefore each firm confronts ahighly elastic demand curve. • Advertising increases ATC • The goals of advertising are to increase demand and make demand more inelastic • The increase in cost of a monopolistically competitive product is the cost of “differentness”

3. Advertising and Monopolistic Competition • Advertising increases ATC • Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do • The goals of advertising are to increase demand and make demand more inelastic • The increase in cost of a monopolistically competitive product is the cost of “differentness” 16-3

4. McHits orMcMisses? Hulaburger - 1962 Filet o Fish - 1963 Strawberry shortcake - 1966 Big Mac - 1968 Hot Apple Pie - 1968 Egg McMuffin - 1975 Drive Thru - 1975 Chicken McNuggets - 1983 Extra Value Meal - 1991 McLean Deluxe - 1991 Arch Deluxe - 1996 55-cent Special - 1997 Big Xtra - 1999 McHorseburger - 2003 McRib, Sundaes and others?

5. Fish Supreme Chicken Parmesan Sandwich 2/3 lb. Monster Thickburger® 1/3 lb. Low Carb Thickburger® Little Thick Cheeseburger 1/4 lb. Little Thickburger® 1/3 lb. Cheeseburger Chili Cheese Thickburger® 1/3 lb. Original Thickburger® 1/3 lb. Mushroom 'N' Swiss Thickburger® 1/3 lb. Bacon Cheese Thickburger® Big Chicken Fillet Sandwich Charbroiled Chicken Club Sandwich Charbroiled BBQ Chicken Sandwich Big Hot Ham 'N' Cheese™ Regular Hamburger Regular Cheeseburger Double Cheeseburger 5-Piece Chicken Breast Strips 7-Piece Chicken Breast Strips Big Shef

7. Price and Output • A profit-maximizing price searcher will expand output as long asmarginal revenueexceedsmarginal cost. • Price will be lowered and output expanded untilMR = MC • The price charged by a price searcher will be greater than itsmarginal cost.

8. Reduction inTotal Revenue Increase inTotal Revenue Marginal Revenue similar to Monopoly • Initial price P1 & output q1. Total revenue (TR) =P1 * q1. Price 1. As price falls from P1 to P2, output increases from q1 to q2, two conflicting influences on TR. P1 1. TR will rise because of an increase in the number of units sold (q2 - q1) * P2. P2 2. TR will decline [(P1 - P2) * q1] as q1 units once sold at the higher price (P1) are now sold at the lower price (P2). d • Depending on the size of the shaded regions, total revenue may increase or decrease. MR Quantity/time q2 q1

9. EconomicProfits Price and Output: Short Run Profit • A monopolistic competitor maximizes profits by producing where MR=MC, at output level q MC Price and charges a price P along the demand curve for that output level. ATC P • At q the average total cost is C. C • What impact will economic profits have if this is a typical firm? d • Because the price is greater than the average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] *q ) MR Quantity/time q

10. Profits and Losses in the Long Run • Economic profitsattract competition. • New firms will expand supply and lower price. • Individual demand curves will shift inward until the economic profits are eliminated. • Economic lossescause firms to leave the market. • Demand for the remaining firms’ output will rise until the losses have been eliminated, ending the incentive to exit. • Firms can make either profits or losses in the short run, but only zero economic profit in the long run.

11. C = P Price and Output: Long Run • Because entry and exit are free, competition will eventually drive prices down to the level ofATC. MC Price • When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored. ATC P • The price searcher establishes its output level whereMC=MR. • At q theaverage total costis equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present. d MR Quantity/time q

12. Profits and Losses Entry and Exit Case 1: Prices rise Profits Entry or Exit? Supply

13. SR Profits 1. Increased Demand, Price goes up 2. Firms enter, Demand faced by each firm decreases Price $6 ATC $5 MC $4 SR Profits $3 Demand $2 3. Price goes down $1 4. No LR Profits 0 10 20 30 40 60 50 Quantity

14. Profits and Losses Entry and Exit Case 2: Prices fall Profits Entry or Exit? Supply

15. SR Losses 1. Demand falls, Price goes down 2. Firms leave, Demand faced by each firm increases Price $6 ATC $5 MC $4 Demand $3 SR Losses $2 3. Price goes up $1 4. No LR Losses 0 10 20 30 40 60 50 Quantity

16. Determining Profits Graphically: Monopolistic Competition P Profits MC ATCLosses ATCL Losses ATCBreak even ATCProfits Break even P ATCP A monopolistic firm can earn profits, losses, or break even in the short run D MR Q Q

17. Pure Comp Mono comp Price Price Quantity/Time Quantity/Time Comparing Markets • LR equilibrium for both. • P= ATCand there are no economic profits. • In monopolistic competition, firms face a downward-sloping demand curve, its profit-maximizing price exceedsMC. • In Monopolistic Competition, output is too small to minimize ATC in long-run equilibrium. MC MC ATC ATC P2 d P1 d MR q1 q2

18. Pure Comp Mono comp Price Price Quantity/Time Quantity/Time Comparing Price Taker Markets • Even though the two markets have the same cost structure, the price in the monopolistic competitor’s market is higher than that in the price-taker’s market ( P2>P1). • Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation). Price Price MC MC ATC ATC P2 d P1 d MR q1 q2

19. Oligopoly Characteristics? 1. Few Sellers 2. Differentiated or Identical Products 3. Difficult Entry and Exit 4. Non-Price competition 5. LR profits/losses 6. Price Maker

20. In any decision a firm makes, it must take into account the expected reaction of other firms • Oligopolies are made up of a small number of firms in an industry • Oligopolistic firms are mutually interdependent • Oligopolies can be collusive or noncollusive • Firms may engage in strategic decision making where each firm takes explicit account of a rival’s expected response to a decision it is making 16-20

21. Empirical Measures of Industry Structure concentration ratio • Theconcentration ratio is a firm’s percentage of total industry sales • TheHerfindahl index is the sum of the squared value of the a firm’s share in the industry Herfindahl index • This gives more weight to firms with large market shares than does the concentration ratio measure

22. Concentration Ratios and the Herfindahl Index

23. Concentration Ratios and the Herfindahl Index - II

24. Game Theory or Strategic Interaction • A non-cooperative game is a game in which each player is out for him- or herself and agreements are either not possible or not enforceable • Cooperative games are games in which players can form coalitions and can enforce the will of the coalition on its members • Sequential games are games where players make decisions one after another, chess, for example • Simultaneous move games are games where players make their decisions at the same time as other players, for example, the prisoner’s dilemma

25. Strategies of Players • Adominant strategy is a strategy that is preferred by a player regardless of the opponent’s move, prisoner’s dilemma, for example • In backward induction, you begin with a desired outcome and then determine the decisions that could have led you to that outcome • A mixed strategy is a strategy of choosing randomly among moves, for example, rock, paper, scissors 11-25

26. Strategic Decision Making Models 1. Payoff Matrix high low A B $59 $57 high $60 $55 C D $55 $50 low $69 $58

27. 2. Kinked Demand Curve price elastic Current Price and Quantity P TR . P inelastic P TR D=AR MC1 MC2 MC3 Q quantity MR

28. Collusion Agreement to fix prices and/or divide market share - helps reduce uncertainty - increases profits - keeps entry difficult

29. Types 1. Overt Collusion a. Formal Agreement to set Prices b. OPEC 2. Covert Collusion a. Secret agreements b. Electric switch makers in the 50s

30. Auction Markets • Standard sealed bid auction is where the person who bids the highest gets the good • Vickrey auctions are a sealed bid auction where the highest bidder wins but pays the price bid by the next highest bidder • Vickrey auctions result in higher bids because people are more likely to bid their willingness to pay

31. Types 3. Gentlemen’s Agreements a. Agree on price then use non-price competition b. Types of agreements 1) Price Leadership - GM -dominant firm set price -others follow 2) Cost-Plus Pricing - Set price based on ATC at 85% capacity

32. Obstacles to Collusion 1. More firms, more likely to cheat 2. Firms may cheat in non-price ways – free services 3. Requires barriers to remain high 4. Unstable demand/business cycles 5. Illegal - use Gentlemen’s agreements 6. Difficult to hold the price

33. Comparison of Market Structures

34. 16 Questions

35. Right after you graduate, you get a job in production management and you are responsible for the entire company on weekends. Here are the costs of production for the company: Quantity Average Total Cost 500 $200 501 $201 Your current level of production is 500 units and all 500 have been ordered by regular customers. One weekend, the phone rings. It is a customer who wants to buy one unit of your product. This means increasing production to 501 units. The customer offers to buy it for $450. Should you accept the offer? What is the net change in the firm’s profit?

36. In a monopolistically competitive market, the firms will a. be able to choose their price, and the entry barriers into the market will be low. b. be able to choose their price, and the entry barriers into the market will be high. c. have to accept the market price for their product, and the entry barriers into the market will be low. d. have to accept the market price for their product, and the entry barriers into the market will be high. A profit-maximizing MC firm will expand output to the point where a. total revenue equals total cost. b. marginal revenue equals marginal cost. c. price equals average total cost. d. price equals marginal cost. In the long run, neither perfectly competitive nor monopolistically competitive firmswill be able to earn economic profits because a. entry barriers into these markets are high, raising the costs of each firm. b. the government will dictate moderate prices for these firms. c. competition will force prices down to the level of per-unit production costs. d. marginal revenue is always less than marginal cost when barriers to entry are low. If a market is in long-run equilibrium, which of the following conditions will be present in a monopolistically competitive market but absent from a perfectly competitive market? a. P = ATC b. MR = MC c. P = MC d. MR < P

37. As long as a market is contestable, then even if it has only a few sellers, the a. threat of new firms will prevent the prices from rising above the competitive level. b. producers will be able to charge prices that are high enough to produce long-run economic profits. c. producers will not face new competition because the barriers to entry are high. d. market will never be expected to come close to the competitive result. If firms in a monopolistically competitive market are currently earning economic losses, then in the long run, a. new firms will enter the market, and the current firms will experience a decrease in demand for their products until zero economic profit is again restored. b. new firms will enter the market, and the current firms will experience an increase in demand for their products until zero economic profit is again restored. c. some existing firms will exit the market, and the remaining firms will experience an increase in demand for their products until zero economic profit is again restored. d. some existing firms will exit the market, and the remaining firms will experience a decrease in demand for their products until zero economic profit is again restored. Compared to the outcome when the firms are price takers, monopolistically competitive markets will result in a. a wider variety of products and higher prices. b. less product variety and higher prices. c. a wider variety of products and lower prices. d. less product variety and lower prices.

38. What price should this monopolistically competitive firm charge in order to maximize profits? • $5b. $7c. $8d. $10 d. $10 What is the maximum economic profit this firm will be able to earn? b. $20 • $0 b. $20 c. $30 d. $100 If these are cost and demand conditions of this firm, what will happen in the future? a. Firms will go out of business, and the market price will rise. b. The current market price will tend to persist into the future. c. New firms will enter the market, and demand facing this firm will decline. d. The firms in this industry probably will collude in order to increase their profitability.

39. The average variable cost (AVC) and average total cost (ATC) for a firm are shown here. If the marginal cost curve were constructed, at what output would it cross the AVC curve? a. 2 b 3 c. 4 d. 5 At what output would a properly constructed marginal cost curve cross the ATC curve? a. 3 b 4 c. 5 d. 6 Calculate the total cost of producing four units. a. $10 b. $15 c $60 d. $75 Calculate the total variable cost of producing three units. a. $10 b. $15 c. $30 d. $45

40. Which output level would be most closely associated with the point where diminishing marginal returns have begun? a 4 b. 5 c. 6 d. 8 Which output minimizes per-unit cost? a. 4 b. 6 c. 7 d 8 Which of the following is true? a. Firms in this industry begin to experience diminishing returns to their variable factors at output q1. b. Between q1 and q2, firms in this industry experience economies of scale. c Firms producing output rates less than q1 or more than q2 will find it difficult to survive. d. The largest firms in this industry have the lowest per-unit cost.

41. The graph illustrates a firm • capable of earning economic profit. • that is only able to break even when it maximizes profit. • c taking economic losses. • d. that should shut down immediately. When price rises from P2 to P3, the firm finds that a. marginal cost exceeds marginal revenue at a production level of Q2. b. if it produces at output level Q3 it will earn a positive profit. c expanding output to Q4 would leave the firm with losses. d. it could increase profits by lowering output from Q3 to Q2. • When price falls from P3 to P1, the firm finds that • fixed cost is higher at a production level of Q1 than it is at Q3. • it should produce Q1 units of output. • c. it should produce Q3 units of output. • d it should shut down immediately.