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17
Monopolistic Competition PRINCIPLES OF
FOURTH EDITION
N. G R E G O R Y M A N K I W PowerPoint Slides by Ron Cronovich 2007 Thomson South-Western, all rights reserved
In this chapter, look for the answers to
these questions: How is monopolistic competition similar to perfect competition? How is it similar to monopoly?
How do monopolistically competitive firms choose
price and quantity? Do they earn economic profit?
In what ways does monopolistic competition affect
societys welfare?
What are the social costs and benefits of
advertising? CHAPTER 17
MONOPOLISTIC COMPETITION
Introduction to Monopolistic Competition
Monopolistic competition: a market structure in which many firms sell products that are similar but not identical.
Examples:
apartments books bottled water clothing fast food night clubs CHAPTER 17
MONOPOLISTIC COMPETITION
Comparing Perfect & Monop. Competition
perfect competition
monopolistic competition
number of sellers
many
many
free entry/exit
yes
yes
long-run econ. profits
zero
zero
the products firms sell
identical
differentiated
firm has market power? none, price-taker
yes
D curve facing firm
downwardsloping
CHAPTER 17
horizontal
MONOPOLISTIC COMPETITION
Comparing Monopoly & Monop.
Competition monopoly
monopolistic competition
number of sellers
one
many
free entry/exit
no
yes
long-run econ. profits
positive
zero
firm has market power?
yes
yes
D curve facing firm
downwarddownwardsloping sloping (market demand)
close substitutes
none
CHAPTER 17
MONOPOLISTIC COMPETITION
many 5
Comparing Oligopoly & Monop.
Competition oligopoly number of sellers
few
monopolistic competition many
importance of strategic high interactions between firms
low
likelihood of fierce competition
high
CHAPTER 17
low
MONOPOLISTIC COMPETITION
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.
Price profit
ATC
P ATC
The firm uses the
D curve to set P. CHAPTER 17
MC
MONOPOLISTIC COMPETITION
D MR Q
Quantity 7
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.
Price
MC losses
ATC
ATC P D MR Q
CHAPTER 17
MONOPOLISTIC COMPETITION
Quantity 8
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. CHAPTER 17
MONOPOLISTIC COMPETITION
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. CHAPTER 17
Price
MC ATC
P = ATC markup D
MC
MONOPOLISTIC COMPETITION
MR Q
Quantity 10
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. CHAPTER 17
MONOPOLISTIC COMPETITION
11
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.
CHAPTER 17
MONOPOLISTIC COMPETITION
12
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. CHAPTER 17
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.
CHAPTER 17
MONOPOLISTIC COMPETITION
14
The Critique of Advertising
Critics of advertising believe: Society is wasting the resources it devotes to advertising.
Firms advertise to manipulate peoples tastes.
Advertising impedes competition it creates the perception that products are more differentiated than they really are, allowing higher markups.
CHAPTER 17
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. CHAPTER 17
MONOPOLISTIC COMPETITION
16
Advertising as a Signal of Quality
A firms 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 company is willing to spend so much on advertising. CHAPTER 17
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
CHAPTER 17
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.
CHAPTER 17
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.
CHAPTER 17
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 markets allocation of resources.
CHAPTER 17
MONOPOLISTIC COMPETITION
21
CHAPTER SUMMARY A monopolistically competitive market has many firms, differentiated products, and free entry.
Each firm in a monopolistically competitive market
has excess capacity produces less than the quantity that minimizes ATC. Each firm charges a price above marginal cost.
CHAPTER 17
MONOPOLISTIC COMPETITION
22
CHAPTER SUMMARY Monopolistic competition does not have all of the desirable welfare properties of perfect competition. There is a deadweight loss caused by the markup of price over marginal cost. Also, the number of firms (and thus varieties) can be too large or too small. There is no clear way for policymakers to improve the market outcome.
CHAPTER 17
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CHAPTER SUMMARY Product differentiation and markup pricing lead to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to reduce competition and take advantage of consumer irrationality. Defenders argue that firms use them to inform consumers and to compete more vigorously on price and product quality.
