Market Structures: Monopolistic Competition

1. AP Economics Mr. Bordelon Market Structures:Monopolistic Competition

2. Basics • Monopolistic competition. Market structure in which there are many competing firms in an industry, each firm sells a differentiated product, and there is free entry into and exit from the industry in the long run.

3. Basics • Three conditions • large number of competing firms • competition limits price control somewhat • differentiated products • each product is somewhat distinct from products of competitors • free entry into and exit from the industry in the long run • depends on profit

4. Monopolistic Competitionin the Short Run Looking at monopolistic competition in a graph, notice the similarity to monopoly with D and MR curves. They slope downward in this case because of the differentiated products: competitors create demand for their products. MC slopes upward like normal, but notice the shape of ATC: U-shaped rather than a curve. This makes a difference in the long run.

5. Monopolistic Competitionin the Short Run Remember, for profit-maximization, MR = MC. In this particular graph, the firm is making a profit. This firm will produce at QP because this is where MR = MC. It will sell at PP, as this is the market price along the D curve where QP intersects. Because at this point P > ATC, the firm is making a profit, which can be calculated through the area of the rectangle.

6. Monopolistic Competitionin the Short Run Now take a look at it from a position of loss. In this case, P < ATC, which indicates automatically there is a loss. The question is, how do we make the loss minimal? MR = MC! It’s the profit-maximization rule, which means this is the most I can produce that will make me the most dough no matter what.

7. Monopolistic Competitionin the Short Run This firm will produce QU where MR = MC. This intersects the D curve at PU, which will be the price the monopolistic competitor charges. The loss can be calculated by finding the area of the rectangle.

8. Monopolistic Competition in the Short Run Comparing side by side, take a look at panel (a) first. Are there any points along the graph at which we could lose profit? Yes! If P < ATC, that is, where ATC rises above D.

9. Monopolistic Competition in the Short Run What about panel (b)? Are there any points along the graph where this firm could actually turn a profit? No! At every point P < ATC, so there is not even the possibility of a normal profit.

10. Monopolistic Competition in the Short Run Monopoly Monopolistic Competition Comparing the graphs side by side, is there a difference? Not really. Just that monopoly happens to be getting more profit here. Why? Well, that’s where the competition comes in.

11. Monopolistic Competition in the Long Run • As we saw, the monopolistic competition graphs looked just like ordinary monopoly graphs, save for the more u-shaped ATC. • The difference in profit ultimately comes from the competition factor of monopolistic competition, which also means entry into and exit from the industry.

12. Monopolistic Competition in the Long Run • Zero-profit equilibrium. In the long run, a monopolistically competitive industry achieves zero profit at its profit-maximizing quantity. • In the graphs above, neither of the firms were at equilibrium. • When profits are negative, some firms will exit. No long-run equilibrium until losses have been eliminated by firms exiting the market (like in perfect competition). • When profits are positive, some firms will enter. No long-run equilibrium until profits have been eliminated by firms entering the market (like in perfect competition).

13. Monopolistic Competition in the Long Run • So if the effects are the same as in perfect competition, why do we care? • In perfect competition, MR and D were perfectly elastic. • In monopolistic competition, MR and D are not perfectly elastic. • Remember, the differentiated products creates a competitive factor that doesn’t exist in perfect competition which deals with commodities.

14. Monopolistic Competition in the Long Run: Entry When firms are profitable in monopolistic competition, more firms will enter the market. As more firms enter, D and MR shift to the left. With each new competitor entering the market, the original competitors will no longer be able to sell as much as before at any given price (they now have to compete more!).

15. Monopolistic Competition in the Long Run: Exit When firms are not profitable in monopolistic competition, firms will exit the market. As more firms exit, D and MR shift to the right. With each competitor exiting the market, the remaining competitors will be able to sell more than before at any given price (they now have to compete less!).

16. Monopolistic Competition in the Long Run • Firms will earn profits so long as P > ATC, or, in graph terms, any part of D is higher than ATC. • Firms will earn losses so long as P < ATC, or, in graph terms, any part of D is lower than ATC. • In zero-profit equilibrium, P = ATC, or, in graph terms, where D is tangent to ATC.

17. Monopolistic Competition in the Long Run At point Z, notice that we’re at our profit-maximization point, where MR = MC. Firms will charge PMC, which also equals ATCMC, and produce at QMC. In this case, entry into and exit from the market structure has stopped. And it will stop when every existing firm makes zero profit at its profit-maximizing quantity. In long-run zero-profit equilibrium, D of each firm is tangent to ATC at profit-maximizing quantity.

18. Monopolistic Competition in the Long Run So how is this like a monopoly? A monopolistic competitive firm is like a monopoly without profits.

19. Monopolistic Competition vs.Perfect Competition Perfect Competition Monopolistic Competition Long-run output:P = ATC > MR = MC Economic profits are zero: Normal profits ftw! • Long-run output:P = MR = MC = ATC • Economic profits are zero: • Normal profits ftw!

20. Monopolistic Competition vs.Perfect Competition Notice that in monopolistic competition, the minimum-cost output is not where the firms will produce. Here, monopolistic competitors are making profits. They will set production where MR = MC. If they were to produce at the minimum-cost output, they would achieve the perfectly competitive outcome.

21. Monopolistic Competition vs. Perfect Competition Focus on the ATC, on where exactly P = ATC. Looking at perfect competition alone, P = ATC at the minimum of the ATC. The level of output being produced is the one that corresponds to the lowest ATC.

22. Monopolistic Competition vs. Perfect Competition Now compare it to monopolistic competition. Here, P = ATC on the downward slope of the ATC. This level of output is smaller than the one that minimizes ATC. This is called excess capacity. Excess capacity. Firms in a monopolistically competitive industry produce less less than the output at which ATC is minimized.

23. Monopolistic Competition vs. Perfect Competition Excess capacity is another difference between monopolistic and perfect competition. In monopolistic competition, firms DO NOT produce the level of output at which ATC is minimized. In monopolistic competition, the entire industry DOES NOT produce these products at the lowest possible cost. So just like monopoly, they will end up with a profit (just a smaller one because of competition). Profit can be calculated as the area of the rectangle.

24. Is Monopolistic Competition Inefficient? • We saw that in monopoly there is DWL when output stops prior to where P = MC. Any time P ≠ MC, improvements in efficiency can be made. • In monopolistic competition, because P > MC, DWL and inefficiency exists. • More competition for consumers, however, make the wedge between P and MC lower than in monopoly. • DWL is smaller in monopolistic competition.

25. Is Monopolistic Competition Inefficient? • Can we live with this DWL? • Probably. The reason why P > MC in monopolistic competition is because we have differentiated products to begin with. This allows some pricing power to a degree.

26. Product Differentiation • Product differentiation. The attempt by firms to convince buyers that their products are different from those of other firms in the industry. • Style/Type • Location • Quality • Differentiation can be real or perceived. • Real: Standard vs. automatic. Chrome vs. plastic. • Perceived: Bleach is bleach. Gas is gas.

27. Product Differentiation • Style or Type. Reality is that people have different tastes. Producers will be able to increase profits by differentiating products to suit those tastes. • Travis really likes Chicago-style pizza, no matter how wrong it is. And it is wrong, Travis. Really. We should talk. You can get help. • No matter how much we try to convince him otherwise, he just likes the cake-like pizza of Chicago. For him, the superior NY-style is an imperfect substitute. • Because the heretic “pizza” maker knows Travis doesn’t know any better about pizza, he can charge Travis a higher price.

28. Product Differentiation • Location. Oftentimes, consumers will choose on the basis of convenience. • My preferred gas station is Murphy Express because it’s near my house in NSB. I personally believe that because it’s nearby, it has to be better than RaceTrac in the OC. • Unfortunately, I pay for the convenience.

29. Product Differentiation • Quality. Reality vs. Perception. Producers will charge higher prices based on this subjective value. • BMWs are clearly superior than those death traps Kia makes. As such, I’m willing to pay more for a BMW.

30. Advertising • Bleach is bleach. Every single bottle of bleach contains sodium hypochlorite, NaClO. • Clorox, however, would have you believe that their bleach is bleachier than other bleaches. • Clorox controls 70% of the bleach market. • Clorox spends millions of dollars to maintain their dominant position in the market. • Is the advertising that Clorox spends money on the best use of economic resources?

31. Advertising: Overlapping Messages Informative Persuasive Often use humor, special effects, etc. to persuade the consumer to buy over those lesser rival products. Our chocolate will make you sexier. Apple Computers make you a better person karma-wise. Just do it. If successful, price can be increased. • Information is designed to persuade a consumer to buy, but some messages are completely void of useful information. • Open 24 hours. • We play both styles of music: country and western. • Delivery available.

32. Advertising • Why does advertising work, if we assume that people act in their own rational self-interest? • The psychological impact of advertising plays a role in how products are perceived. • Michael Jordan wears Nikes. Michael Jordan is the greatest basketball player of all time. Michael Jordan wouldn’t wear a crappy shoe. I think it’s time for me to buy some Jordans.

33. Brand Names • Brand name. Name owned by a particular firm that distinguishes its products from those of other firms. • Establishing a brand name is a valuable advertising tool, especially if you can become the product, be the noun, as it were. • Kleenex vs. tissues • Xerox vs. copier • Coke vs. soda

34. Brand Names • Firms spend obscene amounts of cash to establish a brand name so as to differentiate from competitors and establish themselves. • In 2008, AFLAC spent $78.7 million on advertising. • For a goose. • With Gilbert Gottfried’s annoying voice. • Why? • Why God, why?!? • To establish their brand. • And specifically, what it is they even do. Seriously, prior to AFLAC, how often did you think of supplemental insurance during the Super Bowl?

35. Brand Names • Is spending money to establish a brand name socially useful? Probably. • Brand names convey information. McDonald’s sells Big Macs everywhere, and we know this. • However, it may also persuade consumers to spend too much for a product where the only difference is the name of the label.