Monopolistic Competition

1. Monopolistic Competition The best (worst) of both worlds?

2. Objectives • Explain the characteristics of monopolistic competition. • Explain the nature of profit for a monopolistically competitive firm. • Compare MC to PC. • Evaluate the role of advertising in MC. • Create and analyze the MC graph.

3. Characteristics of Monopolistic Competition • Many firms selling competitive products • Each firm has a small market share • Firms are competitive and do not collude • Firms are independent of each other • Products are heterogeneous (differentiation) • Easy (not perfectly free) entry and exit • Chiefly due to larger start-up costs

4. A little more about Differentiation • Firms in MC will work very hard to make their product different from their competitors. • Product attributes • Customer service • Location • Branding and packaging • Advertising • Because each firm produces a product that they are monopolistic over, the firm faces a downsloping demand curve.

5. Market Concentration • When attempting to determine the nature of a market (competitive vs. monopolistic), economists examine the concentration of control by the firms in the industry. • Two measures: • Concentration Ratios – the percentage of total output produced by the industry’s four largest firms. • Monopoly – 100% • Perfect Competition – 0% (or very close) • Monopolistic competition - 40% or lower • Oligopoly – 40% or higher • Herfindahl Index – the sum of every firm’s percentage market share squared (%S12 + %S22 + %S32 + …) • In perfect competition, HI would be around 0 (02 + 02 + 02…= 0) • In monopoly, HI would be 10,000 (1002 = 10,000) • In monopolistic competition, HI would be between 1,000 and 1,800 according to most economists • In oligopoly, HI would be between 1,800 and 10,000

6. And now, the graph! MC ATC P Profit D = AR MR QMC

7. The Long Run MC Zero Economic Profit ATC P Profit Excess Capacity P > MC D = AR MR QMC

8. MC is not efficient • Productive Inefficiency is smaller than in monopoly, but it is still inefficient. • In Monopolistic Competition, producers will experience excess capacity. They do not produce the quantity that results in the lowest per-unit cost (where MC=ATC) because of overcrowding in the market. This is a sign of productive inefficiency. • Allocative Inefficiency is also present, but at less of a degree than in monopoly. • The price charged is above the marginal cost. In turn, resources are not allocated efficiently • Draw a long-run MC firm vs. a long-run PC firm.

9. What can be done? • Most economists agree that Monopolistic Competition is not efficient. • Many economists believe that attempting to regulate these firms would be more harmful than good. • Consider the cost of determining where MC=P. Consider the number of monopolistically competitive firms… • The overall calculus is that regulation is generally undesired because it would be more burdensome to society than the allocative inefficiency produced by the firms.

10. The Issue of Advertising • Firms that sell highly differentiated products will spend 10-20% of revenue on advertising. • In the US, about $250 billion is spent every year to advertise. • PRO’s: Advertising increases public knowledge and awareness, which allows consumers to make more informed choices, increases competition. • CON’s: Advertising is mostly psychological, not informational, influences desires artificially, increases production costs, impedes competition by fueling false beliefs, increases ‘conspicuous consumption’ (Galbraith)

11. Modern Controversy: DTCA • Direct-to-Consumer-Advertising exists today in the pharmaceutical industry. • Controversy exists about the benefits of allowing these firms to advertise. • Read the two handouts and write a 2 page pro/con analysis: • DTCA is beneficial and should be allowed. • DTCA is harmful and should be regulated/banned. • Your final analysis. Include graphs.