Chapter 16 Vocab Concentration Ratio Percentage of total output in the market supplied by the 4 largest firms Product Variety Externality Because consumers get some consumer surplus from the introduction of a new product entry of a new firm conveys a positive externality on consumers Business Stealing Externality Because other firms lose customers and profits from the entry of a new competitor entry of a new firm imposes a negative externality on existing firms Oligopoly Market structure in which only a FEW sellers offer SIMILAR or IDENTICAL products Monopolistic Competition Market structure in which MANY firms sell products that are SIMILAR but NOT identical Many sellers There are many firms competing for the same group of customers Product differentiation Each firm produces a product that is at least slightly different from those of other firms Thus rather than being a price taker each firm faces a downward sloping demand curve Free entry and exit Firms can enter or exit the market without restriction Thus the number of firms in the market adjusts until economic profits are driven to zero DOWNWARD SLOPING DEMAND CURVE The profit maximizing quantity is found at the intersection of the marginal revenue and marginal cost curves In panel a price exceeds average total cost so the firm makes a profit In panel b price is below average total cost so the firm is unable to make a positive profit so the best the firm can do is to minimize its losses New firms have an incentive to enter the market This entry increases the number of products from which customers can choose and therefore reduces the demand faced by each firm already in the market In other words profit encourages entry and entry shifts the demand curves faced by the incumbent firms to the left As the demand for incumbent firms products falls these firms experience declining profit Conversely when firms are making losses as in panel b firms in the market have an incentive to exit As firms exit customers have fewer products from which to choose This decrease in the number of firms expands the demand faced by those firms that stay in the market In other words losses encourage exit and exit shifts the demand curves of the remaining firms to the right As the demand for the remaining firms products rises these firms experience rising profits that is declining losses This process of entry and exit continues until the firms in the market are making exactly zero economic profit Once the market reaches this equilibrium new firms have no incentive to enter and existing firms have no incentive to exit These two curves must be tangent once entry and exit have driven profit to zero Because profit per unit sold is the difference between price found on the demand curve and average total cost the maximum profit is zero only if these two curves touch each other without crossing Also note that this point of tangency occurs at the same quantity where marginal revenue equals marginal cost That these two points line up is not a coincidence It is required because this particular quantity maximizes profit and the maximum profit is exactly zero in the long run As in a monopoly market price exceeds marginal cost This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward sloping demand curve makes marginal revenue less than the price As in a competitive market price equals average total cost This conclusion arises because free entry and exit drive economic profit to zero As we have just seen entry and exit drive each firm in a monopolistically competitive market to a point of tangency between its demand and average total cost curves Panel a shows that the quantity of output at this point is smaller than the quantity that minimizes average total cost Thus under monopolistic competition firms produce on the downward sloping portion of their average total cost curves As panel b shows free entry in competitive markets drives firms to produce at the minimum of average total cost For a competitive firm such as that shown in panel b price equals marginal cost For a monopolistically competitive firm such as that shown in panel a price exceeds marginal cost because the firm always has some market power Efficient Scale The quantity of output that minimizes ATC Firms are said to have excess capacity under monopolistic competition In other words a monopolistically competitive firm unlike a perfectly competitive firm could increase the quantity it produces and lower the average total cost of production The firm forgoes this opportunity because it would need to cut its price to sell the additional output It is more profitable for a monopolistic competitor to continue operating with excess capacity The zero profit condition ensures only that price equals average total cost It does not ensure that price equals marginal cost Indeed in the long run equilibrium monopolistically competitive firms operate on the declining portion of their average total cost curves so marginal cost is below average total cost Thus for price to equal average total cost price must be above marginal cost In this relationship between price and marginal cost we see a key behavioral difference between perfect competitors and monopolistic competitors Imagine that you were to ask a firm the following question Would you like to see another customer come through your door ready to buy from you at your current price A perfectly competitive firm would answer that it didn t care Because price exactly equals marginal cost the profit from an extra unit sold is zero By contrast a monopolistically competitive firm is always eager to get another customer Because its price exceeds marginal cost an extra unit sold at the posted price means more profit Markup of price over marginal cost is an INEFFICIENCY because consumers who value the good more than the marginal cost of production but less than the price will be deterred from buying it Monopolistically Competitive markets have DWL like Monopoly pricing Highly differentiated goods Most Spent Advertising 10 20 Industrial Products Spend very little on Advertising Homogeneous Products No spending on Advertising at all Economy as a whole 2 of revenue is spent on Advertising Critics of Advertising argues that firms advertise to manipulate people s tastes and that advertising impedes on competition Advertising is Psychological rather than Informational Advertising often tries to convince consumers
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