MONOPOLISTIC COMPETITION

1. MONOPOLISTIC COMPETITION 0 Ch.16 Monopolistic Competition Professor Sumner La Croix Econ 130(3) University of Hawai'i-Manoa November 23-25, 2009 In the preceding two chapters, we studied the two extremes of the competition spectrum. This chapter focuses on monopolistic competition, one of the market structures in between the two extremes. Examples of each market type: Perfect competition: wheat, milk Monopoly: tap water, cable TV Oligopoly: tennis balls, cigarettes Monopolistic competition: novels, movies In the preceding two chapters, we studied the two extremes of the competition spectrum. This chapter focuses on monopolistic competition, one of the market structures in between the two extremes. Examples of each market type: Perfect competition: wheat, milk Monopoly: tap water, cable TV Oligopoly: tennis balls, cigarettes Monopolistic competition: novels, movies

2. MONOPOLISTIC COMPETITION 1 Introduction: Between Monopoly and Competition Two extremes Perfect competition: many firms, identical products Monopoly: one firm In between these extremes: imperfect competition Oligopoly: only a few sellers offer similar or identical products. Monopolistic competition: many firms sell similar but not identical products. In the preceding two chapters, we studied the two extremes of the competition spectrum. This chapter focuses on monopolistic competition, one of the market structures in between the two extremes. Examples of each market type: Perfect competition: wheat, milk Monopoly: tap water, cable TV Oligopoly: tennis balls, cigarettes Monopolistic competition: novels, movies In the preceding two chapters, we studied the two extremes of the competition spectrum. This chapter focuses on monopolistic competition, one of the market structures in between the two extremes. Examples of each market type: Perfect competition: wheat, milk Monopoly: tap water, cable TV Oligopoly: tennis balls, cigarettes Monopolistic competition: novels, movies

3. MONOPOLISTIC COMPETITION 2 Characteristics & Examples of Monopolistic Competition Characteristics: Many sellers Product differentiation Free entry and exit Examples: apartments books bottled water clothing fast food night clubs Another important dimension of product differentiation, not emphasized in the book, is location. Gasoline seems like an undifferentiated product, yet different gas stations charge different prices. How can some gas stations get away with charging 5 or even 10 cents more per gallon? The answer is product differentiation by location. Imagine you�re driving home in rush-hour traffic from a grueling 10-hour day at the office. The orange warning light comes on, indicating your car needs gas. After uttering a few choice expletives, you notice two gas stations at an upcoming intersection. The one on the right charges 5 cents more than the one on the left, but is easily accessible. The one on the left would require you to make a left-hand turn in heavy traffic to get into the station, and another to get out. And how much would you save? If you buy 20 gallons, you�d save only $1. Alternatively, imagine you run a gas station located in a highly residential area, in which there are few other businesses � including gas stations. If people want gas, they can buy it from you, or they can drive 10 minutes to a more commercial area with lots of gas stations. Your location allows you to charge a higher price. Business people have long understood that location is a critical dimension of product differentiation. Hence the saying �location, location, location.� Another important dimension of product differentiation, not emphasized in the book, is location. Gasoline seems like an undifferentiated product, yet different gas stations charge different prices. How can some gas stations get away with charging 5 or even 10 cents more per gallon? The answer is product differentiation by location. Imagine you�re driving home in rush-hour traffic from a grueling 10-hour day at the office. The orange warning light comes on, indicating your car needs gas. After uttering a few choice expletives, you notice two gas stations at an upcoming intersection. The one on the right charges 5 cents more than the one on the left, but is easily accessible. The one on the left would require you to make a left-hand turn in heavy traffic to get into the station, and another to get out. And how much would you save? If you buy 20 gallons, you�d save only $1. Alternatively, imagine you run a gas station located in a highly residential area, in which there are few other businesses � including gas stations. If people want gas, they can buy it from you, or they can drive 10 minutes to a more commercial area with lots of gas stations. Your location allows you to charge a higher price. Business people have long understood that location is a critical dimension of product differentiation. Hence the saying �location, location, location.�

4. MONOPOLISTIC COMPETITION 3 Comparing Perfect & Monop. Competition That long-run profits are zero follows from free entry/exit. The market power of a monopolistic competitor follows from the fact that it sells a product that is at least somewhat different from products sold by other firms. The D curve facing a monopolistically competitive firm is downward-sloping because the firm has a bit of market power and sells a unique variety. That long-run profits are zero follows from free entry/exit. The market power of a monopolistic competitor follows from the fact that it sells a product that is at least somewhat different from products sold by other firms. The D curve facing a monopolistically competitive firm is downward-sloping because the firm has a bit of market power and sells a unique variety.

5. MONOPOLISTIC COMPETITION 4 Comparing Monopoly & Monop. Competition For monopolistic competition, free entry/exit drives profits to zero in the long run. In contrast, barriers to entry prevent the monopolist�s profits from being driven to zero. A monopoly is the sole seller of a product with no close substitutes. In contrast, the monopolistic competitor sells a product with many close substitutes. As a result, demand for the monopolist�s product is less elastic than demand for the monopolistic competitor�s product. For monopolistic competition, free entry/exit drives profits to zero in the long run. In contrast, barriers to entry prevent the monopolist�s profits from being driven to zero. A monopoly is the sole seller of a product with no close substitutes. In contrast, the monopolistic competitor sells a product with many close substitutes. As a result, demand for the monopolist�s product is less elastic than demand for the monopolistic competitor�s product.

6. MONOPOLISTIC COMPETITION 5 A Monopolistically Competitive Firm Earning Profits in the Short Run The firm faces a downward-sloping D curve. At each Q, MR < P. To maximize profit, firm produces Q where MR = MC. The firm uses the D curve to set P. The graphical analysis of the monopolistically competitive firm�s output, price, and profits/losses is very similar to that of the monopoly firm. One subtle difference is that the demand curve (and MR curve) facing the monopolistically competitive firm is likely to be flatter than the demand curve facing the monopolist, as the monopolistic competitor faces competition from other firms selling similar products. The graphical analysis of the monopolistically competitive firm�s output, price, and profits/losses is very similar to that of the monopoly firm. One subtle difference is that the demand curve (and MR curve) facing the monopolistically competitive firm is likely to be flatter than the demand curve facing the monopolist, as the monopolistic competitor faces competition from other firms selling similar products.

7. MONOPOLISTIC COMPETITION 6 A Monopolistically Competitive Firm With Losses in the Short Run For this firm, P < ATC at the output where MR = MC. The best this firm can do is to minimize its losses.

8. MONOPOLISTIC COMPETITION 7 Monopolistic Competition and Monopoly Short run: Under monopolistic competition, firm behavior is very similar to monopoly. Long run: In monopolistic competition, entry and exit drive economic profit to zero. If profits in the short run: New firms enter market, taking some demand away from existing firms, prices and profits fall. If losses in the short run:Some firms exit the market,remaining firms enjoy higher demand and prices.

9. MONOPOLISTIC COMPETITION 8 A Monopolistic Competitor in the Long Run Entry and exit occurs until P = ATC and profit = zero. Notice that the firm charges a markup of price over marginal cost and does not produce at minimum ATC. The level of output that minimizes ATC is greater than the output that maximizes the monopolistic competitor�s profits. Hence, we say the monopolistic competitor operates with excess capacity. (More on this topic on the next slide.) The level of output that minimizes ATC is greater than the output that maximizes the monopolistic competitor�s profits. Hence, we say the monopolistic competitor operates with excess capacity. (More on this topic on the next slide.)

10. MONOPOLISTIC COMPETITION 9 Why Monopolistic Competition Is Less Efficient than Perfect Competition 1. Excess capacity The monopolistic competitor operates on the downward-sloping part of its ATC curve, produces less than the cost-minimizing output. Under perfect competition, firms produce the quantity that minimizes ATC. 2. Markup over marginal cost Under monopolistic competition, P > MC. Under perfect competition, P = MC. Due to the markup of price over marginal cost, the market output under monopolistic competition will be smaller than the socially efficient output, as we discuss on the following slide. Due to the markup of price over marginal cost, the market output under monopolistic competition will be smaller than the socially efficient output, as we discuss on the following slide.

11. MONOPOLISTIC COMPETITION 10 Monopolistic Competition and Welfare Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. Because P > MC, the market quantity is below the socially efficient quantity. Yet, not easy for policymakers to fix this problem: Firms earn zero profits, so cannot require them to reduce prices. The problem facing policymakers here is similar to the problem arising from natural monopoly: With natural monopoly, ATC is always falling, so MC is below ATC. If regulators force a natural monopoly to price at marginal cost, it will incur losses. The problem facing policymakers here is similar to the problem arising from natural monopoly: With natural monopoly, ATC is always falling, so MC is below ATC. If regulators force a natural monopoly to price at marginal cost, it will incur losses.

12. MONOPOLISTIC COMPETITION 11 Monopolistic Competition and Welfare Number of firms in the market may not be optimal, due to external effects from the entry of new firms: The product-variety externality: surplus consumers get from the introduction of new products The business-stealing externality: losses incurred by existing firms when new firms enter market The inefficiencies of monopolistic competition are subtle and hard to measure. No easy way for policymakers to improve the market outcome. One of these externalities is positive, the other is negative. It�s not clear which one is bigger, and it may in fact differ by industry. One of these externalities is positive, the other is negative. It�s not clear which one is bigger, and it may in fact differ by industry.

13. A C T I V E L E A R N I N G 1 Advertising 1. So far, we have studied three market structures: perfect competition, monopoly, and monopolistic competition. In each of these, would you expect to see firms spending money to advertise their products? Why or why not? 2. Is advertising good or bad from society�s viewpoint? Try to think of at least one �pro� and �con.� Consider breaking up your lecture with a 10 minute discussion. First, give your students a few quiet moments to formulate their responses. Then, ask for volunteers to share their answers. If you have a chalkboard or dry-erase board, concisely paraphrase each student�s response as it is volunteered. If a student volunteers a �wrong� answer, write it down anyway. After the class has generated a list, have the class go over each item on the list to make sure it really belongs on the list. Benefits: 1) Breaks up the lecture into chunks. 2) Engages students. 3) Gets students to think about the implications of the market structures they�ve studied so far. (Hopefully, some will recognize that product differentiation is a critical determinant of firms� motivation to spend on advertising.) 4) Makes students feel invested in learning the second half of the chapter. Consider breaking up your lecture with a 10 minute discussion. First, give your students a few quiet moments to formulate their responses. Then, ask for volunteers to share their answers. If you have a chalkboard or dry-erase board, concisely paraphrase each student�s response as it is volunteered. If a student volunteers a �wrong� answer, write it down anyway. After the class has generated a list, have the class go over each item on the list to make sure it really belongs on the list. Benefits: 1) Breaks up the lecture into chunks. 2) Engages students. 3) Gets students to think about the implications of the market structures they�ve studied so far. (Hopefully, some will recognize that product differentiation is a critical determinant of firms� motivation to spend on advertising.) 4) Makes students feel invested in learning the second half of the chapter.

14. MONOPOLISTIC COMPETITION 13 Advertising In monopolistically competitive industries, product differentiation and markup pricing lead naturally to the use of advertising. In general, the more differentiated the products, the more advertising firms buy. Economists disagree about the social value of advertising. This section of the textbook has a nice FYI box contrasting the views on advertising of John Kenneth Galbraith and Frederic Hayek, two of the great economists of the 20th century. This section of the textbook has a nice FYI box contrasting the views on advertising of John Kenneth Galbraith and Frederic Hayek, two of the great economists of the 20th century.

15. MONOPOLISTIC COMPETITION 14 The Critique of Advertising Critics of advertising believe: Society is wasting the resources it devotes to advertising. Firms advertise to manipulate people�s tastes. Advertising impedes competition � it creates the perception that products are more differentiated than they really are, allowing higher markups.

16. MONOPOLISTIC COMPETITION 15 The Defense of Advertising Defenders of advertising believe: It provides useful information to buyers. Informed buyers can more easily find and exploit price differences. Thus, advertising promotes competition and reduces market power. Results of a prominent study: Eyeglasses were more expensive in states that prohibited advertising by eyeglass makers than in states that did not restrict such advertising. The study mentioned here was by economist Lee Benham, published in the Journal of Law and Economics in 1972. The textbook has a case study that discusses this research in more detail. The study mentioned here was by economist Lee Benham, published in the Journal of Law and Economics in 1972. The textbook has a case study that discusses this research in more detail.

17. MONOPOLISTIC COMPETITION 16 Advertising as a Signal of Quality A firm�s willingness to spend huge amounts on advertising may signal the quality of its product to consumers, regardless of the content of ads. Ads may convince buyers to try a product once, but the product must be of high quality for people to become repeat buyers. The most expensive ads are not worthwhile unless they lead to repeat buyers. When consumers see expensive ads, they think the product must be good if the companyis willing to spend so much on advertising.

18. MONOPOLISTIC COMPETITION 17 Brand Names In many markets, brand name products coexist with generic ones. Firms with brand names usually spend more on advertising, charge higher prices for the products. As with advertising, there is disagreement about the economics of brand names�

19. MONOPOLISTIC COMPETITION 18 The Critique of Brand Names Critics of brand names believe: Brand names cause consumers to perceive differences that do not really exist. Consumers� willingness to pay more for brand names is irrational, fostered by advertising. Eliminating govt protection of trademarks would reduce influence of brand names, result in lower prices.

20. MONOPOLISTIC COMPETITION 19 The Defense of Brand Names Defenders of brand names believe: Brand names provide information about quality to consumers. Companies with brand names have incentive to maintain quality, to protect the reputation of their brand names.

21. MONOPOLISTIC COMPETITION 20 CONCLUSION Differentiated products are everywhere; examples of monopolistic competition abound. The theory of monopolistic competition describes many markets in the economy, yet offers little guidance to policymakers looking to improve the market�s allocation of resources.