Monopolistic Competition

9.1 AN INTRODUCTION TO MONOPOLISTIC COMPETITION

Monopolistic competition involves many firms competing against each other, but selling
products that are distinctive in some way. Examples include stores that sell different styles of
clothing; restaurants or grocery stores that sell a variety of food; and even products like golf
balls or beer that may be at least somewhat similar but differ in public perception because of
advertising and brand names. There are over 600,000 restaurants in the United States. When
products are distinctive, each firm has a mini-monopoly on its particular style or flavor or
brand name. However, firms producing such products must also compete with other styles
and flavors and brand names.

Differentiated Products

A firm can try to make its products different from those of its competitors in several ways:
physical aspects of the product, location from which it sells the product, intangible aspects of
the product, and perceptions of the product. We call products that are distinctive in one of
these ways differentiated products.

Physical aspects of a product include all the phrases you hear in advertisements: unbreakable
bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for
your comfort. A firm’s location can also create a difference between producers. For example,
a gas station located at a heavily traveled intersection can probably sell more gas, because
more cars drive by that corner. A supplier to an automobile manufacturer may find that it is
an advantage to locate close to the car factory.

Intangible aspects can differentiate a product, too. Some intangible aspects may be promises
like a guarantee of satisfaction or money back, a reputation for high quality, services like free
delivery, or offering a loan to purchase the product. Finally, product differentiation may
occur in the minds of buyers. For example, many people could not tell the difference in taste
between common varieties of ketchup or mayonnaise if they were blindfolded but, because of
past habits and advertising, they have strong preferences for certain brands. Advertising can
play a role in shaping these intangible preferences.

The concept of differentiated products is closely related to the degree of variety that is
available. If everyone in the economy wore only blue jeans, ate only white bread, and drank
only tap water, then the markets for clothing, food, and drink would be much closer to
perfectly competitive. The variety of styles, flavors, locations, and characteristics creates
product differentiation and monopolistic competition.

The Oxymoron

An oxymoron is defined by Google Dictionary as: “a figure of speech in which apparently

contradictory terms appear in conjunction.” This explains the term monopolistic competition
well. A monopoly is defined as a situation where one firm controls the market for some good.
Competition refers to a situation where firms battle with other firms for customers and sales.
How can we put these two words together?

Monopolistic competition refers to a situation where firms have a monopoly on their own
product but they must compete in that market sector. For example, McDonald’s holds a
monopoly on the Big Mac hamburger, but must compete with other fast food restaurants for
both hamburger and fast food sales.

The Demand in the Market Structures

A monopolistically competitive firm perceives a demand for its goods that is an intermediate
case between monopoly and competition. Figure 9.1 offers a reminder that the demand curve
that a perfectly competitive firm faces is perfectly elastic or flat, because the perfectly
competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the
demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is
the only firm in the market, and hence is downward sloping.

Figure 9.1: Three Demand Curves

The demand curve as a monopolistic competitor faces is not flat, but rather downward-
sloping, which means that the monopolistic competitor can raise its price without losing all of
its customers or lower the price and gain more customers. Since there are substitutes, the
demand curve facing a monopolistically competitive firm is more elastic than that of a
monopoly where there are no close substitutes. If a monopolist raises its price, some
consumers will choose not to purchase its product—but they will then need to buy a
completely different product. However, when a monopolistic competitor raises its price, some
consumers will choose not to purchase the product at all, but others will choose to buy a
similar product from another firm. If a monopolistic competitor raises its price, it will not
lose as many customers as would a perfectly competitive firm, but it will lose more customers
than would a monopoly that raised its prices.

At a glance, the demand curves that a monopoly and a monopolistic competitor face look
similar—that is, they both slope down. However, the underlying economic meaning of these
perceived demand curves is different, because a monopolist faces the market demand curve
and a monopolistic competitor does not. Rather, a monopolistically competitive firm’s
demand curve is but one of many firms that make up the “before” market demand curve.
 9.2 MARKET CONSIDERATIONS FOR MONOPOLISTICALLY COMPETITIVE
FIRMS

Profit Maximization in Monopolistic Competition

The monopolistically competitive firm decides on its profit-maximizing quantity and price in
much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a
downward-sloping demand curve, and so it will choose some combination of price and
quantity along its perceived demand curve. For the sake of time, we will not repeat the
process since it is strikingly similar to problems we have already done so far.

Although the process by which a monopolistic competitor makes decisions about quantity
and price is similar to the way in which a monopolist makes such decisions, two differences
are worth remembering. First, although both a monopolist and a monopolistic competitor face
downward-sloping demand curves, the monopolist’s perceived demand curve is the market
demand curve, while the perceived demand curve for a monopolistic competitor is based on
the extent of its product differentiation and how many competitors it faces. Second, a
monopolist is surrounded by barriers to entry and need not fear entry, but a monopolistic
competitor who earns profits must expect the entry of firms with similar, but differentiated,
products.

Entry and Exit

If one monopolistic competitor earns positive economic profits, other firms will be tempted to
enter the market. A gas station with a great location must worry that other gas stations might
open across the street or down the road—and perhaps the new gas stations will sell coffee or
have a carwash or some other attraction to lure customers. A successful restaurant with a
unique barbecue sauce must be concerned that other restaurants will try to copy the sauce or
offer their own unique recipes. A laundry detergent with a great reputation for quality must
take note that other competitors may seek to build their own reputations.

The entry of other firms into the same general market (like gas, restaurants, or detergent)
shifts the demand curve that a monopolistically competitive firm faces. As more firms enter
the market, the quantity demanded at a given price for any particular firm will decline, and
the firm’s perceived demand curve will shift to the left. As a firm’s perceived demand curve
shifts to the left, its marginal revenue curve will shift to the left, too. The shift in marginal
revenue will change the profit-maximizing quantity that the firm chooses to produce, since
marginal revenue will then equal marginal cost at a lower quantity.

As long as the firm is earning positive economic profits, new competitors will continue to
enter the market, reducing the original firm’s demand and marginal revenue curves. When
price is equal to average cost, economic profits are zero. Thus, although a monopolistically
competitive firm may earn positive economic profits in the short term, the process of new
entry will drive down economic profits to zero in the long run. Remember that zero economic
profit is not equivalent to zero accounting profit. A zero economic profit means the firm’s
accounting profit is equal to what its resources could earn in their next best use. We can also
have the reverse situation, where a monopolistically competitive firm is originally losing
money. The adjustment to long-run equilibrium is analogous to the previous example. The
economic losses lead to firms exiting, which will result in increased demand for this
particular firm, and consequently lower losses. Firms exit up to the point where there are no
more losses in this market, for example when the demand curve touches the average cost
curve.

Monopolistic competitors can make an economic profit or loss in the short run, but in the
long run, entry and exit will drive these firms toward a zero economic profit outcome.
However, the zero economic profit outcome in monopolistic competition looks different from
the zero economic profit outcome in perfect competition in several ways relating both to
efficiency and to variety in the market.

Monopolistic Competition and Efficiency

The long-term result of entry and exit in a perfectly competitive market is that all firms end
up selling at the price level determined by the lowest point on the average cost curve. This
outcome is why perfect competition displays productive efficiency: goods are produced at the
lowest possible average cost. However, in monopolistic competition, the end result of entry
and exit is that firms end up with a price that lies on the downward-sloping portion of the
average cost curve, not at the very bottom of the AC curve. Thus, monopolistic competition
will not be productively efficient.

In a perfectly competitive market, each firm produces at a quantity where price is set equal to
marginal cost, both in the short and long run. This outcome is why perfect competition
displays allocative efficiency: the social benefits of additional production, as measured by the
marginal benefit, which is the same as the price, equal the marginal costs to society of that
production. In a monopolistically competitive market, the rule for maximizing profit is to set
MR = MC—and price is higher than marginal revenue, not equal to it because the demand
curve is downward sloping. When P > MC, which is the outcome in a monopolistically
competitive market, the benefits to society of providing additional quantity, as measured by
the price that people are willing to pay, exceed the marginal costs to society of producing
those units. A monopolistically competitive firm does not produce more, which means that
society loses the net benefit of those extra units. This is the same argument we made about
monopoly, but in this case the allocative inefficiency will be smaller. Thus, a
monopolistically competitive industry will produce a lower quantity of a good and charge a
higher price for it than would a perfectly competitive industry.

9.3 ADVERTISING

From: https://en.wikipedia.org/wiki/Advertising

Theory of Advertising

Advertising is a marketing communication that employs an openly sponsored, non-personal

message to promote or sell a product, service or idea.[1]:465 Sponsors of advertising are typically
businesses wishing to promote their products or services. Advertising is differentiated from
public relations in that an advertiser pays for and has control over the message. It differs from
personal selling in that the message is non-personal, i.e., not directed to a particular
individual.[1]:661,672 Advertising is communicated through various mass media,
[2]
 including traditional media such as newspapers, magazines, television, radio, outdoor
advertising or direct mail; and new media such as search results, blogs, social media,
websites or text messages. The actual presentation of the message in a medium is referred to
as an advertisement, or “ad” or advert for short.

Commercial ads often seek to generate increased consumption of their products or services
through “branding“, which associates a product name or image with certain qualities in the
minds of consumers. On the other hand, ads that intend to elicit an immediate sale are known
as direct-response advertising. Non-commercial entities that advertise more than consumer
products or services include political parties, interest groups, religious organizations and
governmental agencies. Non-profit organizations may use free modes of persuasion, such as
a public service announcement. Advertising may also help to reassure employees or
shareholders that a company is viable or successful.

Modern advertising originated with the techniques introduced with tobacco advertising in the
1920s, most significantly with the campaigns of Edward Bernays, considered the founder of
modern, “Madison Avenue” advertising.[3][4]

Worldwide spending on advertising in 2015 amounted to an estimated US$529.43 billion.

[5]
 Advertising’s projected distribution for 2017 was 40.4% on TV, 33.3% on digital, 9% on
newspapers, 6.9% on magazines, 5.8% on outdoor and 4.3% on radio.[6] Internationally, the
largest (“Big Five”) advertising-agency groups are Dentsu, Interpublic, Omnicom, Publicis,
and WPP.[7]

In Latin, advertere means “to turn towards”.[8]

Sales promotions are another way to advertise. Sales promotions are double purposed
because they are used to gather information about what type of customers one draws in and
where they are, and to jump start sales. Sales promotions include things like contests and
games, sweepstakes, product giveaways, samples coupons, loyalty programs, and discounts.
The ultimate goal of sales promotions is to stimulate potential customers to action.[92]

Criticism of Advertising

While advertising can be seen as necessary for economic growth,[27] it is not without social
costs. Unsolicited commercial e-mail and other forms of spam have become so prevalent as
to have become a major nuisance to users of these services, as well as being a financial
burden on internet service providers.[93] Advertising is increasingly invading public spaces,
such as schools, which some critics argue is a form of child exploitation.[94] This increasing
difficulty in limiting exposure to specific audiences can result in negative backlash for
advertisers.[95] In tandem with these criticisms, the advertising industry has seen low approval
rates in surveys and negative cultural portrayals.[96]

One of the most controversial criticisms of advertisement in the present day is that of the
predominance of advertising of foods high in sugar, fat, and salt specifically to children.
Critics claim that food advertisements targeting children are exploitive and are not
sufficiently balanced with proper nutritional education to help children understand the
consequences of their food choices. Additionally, children may not understand that they are
being sold something, and are therefore more impressionable.[97] Michelle Obama has
criticized large food companies for advertising unhealthy foods largely towards children and
has requested that food companies either limit their advertising to children or advertise foods
that are more in line with dietary guidelines.[98] The other criticisms include the change that
are brought by those advertisements on the society and also the deceiving ads that are aired
and published by the corporations. Cosmetic and health industry are the ones which exploited
the highest and created reasons of concern.[99]