Monopolistic Competition

1. Monopolistic Competition Chapter 11

2. In This Chapter… • 11.1. Distinguishing Features of Monopolistically Competitive Markets • 11.2. Profit Maximizing Price and Output Decisions • 11.3. Problems of Monopolistically Competitive Markets

3. 11.1. Distinguishing Features of Monopolistically Competitive Markets

4. Structure • Monopolistic competition is a market in which many firms produce similar goods or services but each maintains some independent control of its own price.

5. Structure • A distinguishing structural characteristic of monopolistic competition is that there are “many” firms in the industry. • “Many” is somewhere between the “few” of oligopolies and the “hordes” that characterize perfect competition.

6. Low Concentration • Low concentration ratios are common in monopolistic competition. • Concentration ratio – The proportion of total industry output produced by the largest firms (usually the four largest).

7. Market Power • Each producer in monopolistic competition is large enough to have some market power. • Market Power – The ability to alter the market price of a good or service.

8. Market Power • A monopolistically competitive firm confronts a downward-sloping demand curve for its output.

9. Independent Production Decisions • Modest changes in the output or price of any single firm will have no perceptible influence on the sales of any other firm.

10. Independent Production Decisions • The relative independence of monopolist competitors means that they don’t have to worry about retaliatory responses to every price or output change.

11. Low Entry Barriers • Another characteristic of monopolistic competition is the presence of low barriers to entry. • Barriers to entry – Obstacles that make it difficult or impossible for would-be producers to enter a particular market, such as patents.

12. Behavior • Monopolistic competition has distinctive behavior.

13. Product Differentiation • One of the most notable features of monopolistically competitive behavior is product differentiation. • Product differentiation - Features that make one product appear different from competing products in the same market.

14. Brand Image • Each firm has a distinct identity – a brand image. • Consumers perceive its output to be somewhat different than others in the industry.

15. Brand Loyalty • By differentiating their products, monopolistic competitors establish brand loyalty. • Brand loyalty gives producers greater control over the price of their products.

16. Brand Loyalty • Each firm only has a monopoly on its brand image. • It still competes with other firms offering close substitutes.

17. Brand Loyalty • Brand loyalty makes the demand curve facing the firm less price-elastic. • Brand loyalty implies that consumers shun substitute goods even when they are cheaper.

18. Brand Loyalty • Each monopolistically competitive firm will establish some consumer loyalty. • A symptom of brand loyalty is the price differences between computers which are essentially the same.

19. 11.2. Profit Maximizing Price and Output Decisions

20. Short-Run Price and Output • The monopolistically competitive firm’s production decision is similar to that of a monopolist. • Production decision - The selection of the short-run rate of output (with existing plant and equipment).

21. Short-Run Price and Output • As always, the profit-maximizing rate of output is achieved by producing the quantity where MR = MC.

22. Entry and Exit • With low barriers to entry, new firms will enter the market if there is economic profit. • Economic profit – The difference between total revenues and total economic costs.

23. Entry and Exit • When firms enter a monopolistically competitive industry: • Thus, in the long run, there are no economic profits in monopolistic competition. • The market supply curve shifts to the right. • The demand curves facing individual firms shift to the left.

24. The short run MC F ATC pa Price or Cost (dollars per unit) ca Demand K MR 0 qa Quantity (units per period) Equilibrium in Monopolistic Competition

25. Effect of entry on the monopolistically competitive firm Effect of entry on the industry Initial market supply Later market supply Initial demand facing firm Price (per unit) Price (per unit) Market demand New entry Quantity (units per time period) Quantity (units per time period) Effects of Entry on Industry and Firm Reduced market share p1 p2 Later demand facing film MR

26. The short run The long run MC MC F ATC pa ATC Price or Cost (dollars per unit) Price or Cost (dollars per unit) G pg Initial demand ca Demand K Later demand MR 0 0 qa qg Later MR Quantity (units per period) Quantity(units per period) Equilibrium in Monopolistic Competition

27. 11.3. Problems of Monopolistically Competitive Markets

28. Inefficiency • Monopolistic competition tends to be less efficient in the long run than a perfectly competitive industry.

29. Excess Capacity • Because of the industry-wide excess capacity, each firm produces a rate of output that is less than its minimum ATC. • I.e., the same level of industry output could be produced at lower cost with fewer firms. • The Industry has excess capacity…

30. Flawed Price Signals • The monopolistically competitive firm will always price its output above the level of marginal cost.

31. Flawed Price Signals • Monopolistic competition results in both production inefficiency (above-minimum average cost) and allocative inefficiency (wrong mix of output).

32. Advertising Wars: No Cease-Fire • In truly (perfectly) competitive industries, firms compete on the basis of price. • Imperfectly competitive firms engage in nonprice competition – the most prominent form being advertising.

33. Advertising Wars: No Cease-Fire • Advertising may be more responsible for brand loyalty than the taste of the product. • Having a recognizable name is worth billions in sales.