Chapter 16: Monopolistic Competition Between Monopoly and Perfect Competition - Many industries fall somewhere between the cases of perfect competition and monopoly (imperfect competition) o Firms face competition, but the competition is not so rigorous as to make the firm a price taker. o Firms have market power, but it is not so great that the firm can be an exact monopoly.- Oligopoly : a market structure in which only a few sellers offer similar or identicalproducts. o Concentration ratio: the percentage of total output in the market supplied by the four largest firms. Cereal firms, aircraft manufacturing firms, electric lamp bulb firms, and cigarettes firms are all oligopolies. - Monopolistic Competition : a market structure in which many firms sell products that are similar but not identical. o Many sellers: high competition for same customer base.o Product differentiation: slight variation in product, regular downward sloping demand curve.o Free entry and exit: number of firms adjust until economic profit is zero.Competition with Differentiated ProductsThe Monopolistically Competitive Firm in the Short Run- Downward sloping demand curve. - Follows monopolist’s rule for profit maximization: it chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demandcurve to find the price at which it can sell that quantity. - Profit- maximization quantity is found at intersection of the MR and MC cost curves. o When ATC is above price= losso When ATC is below price= profitThe Long- Run Equilibrium- Profit encourages entry in the market, and entry shifts the demand curves faced bythe new firms to the left. As the demand for the firms’ products falls, since more firms are now in the market (more options to choose from), the firms experience declining profit. When firms are making a negative profit, they have an incentive to leave the market. As firms exit, customers have fewer products to choose from, and demand expands by those firms that stay in the market. Demand curve shifts to the right. o Entry and exit continue until the firms in the market reach zero economic profit. At equilibrium, firms have no incentive to enter or exit the market.- Maximum profit is zero only if the price and ATC aren’t intersecting but touching(Price=ATC). Same quantity as MR equals MC. - Difference between monopoly and monopolistically competitive market: monopoly makes positive economic profit in the long run, but monopolistically competitive markets reach zero in the long run.Monopolistic Versus Perfect Competition- Differences between monopolistic and perfect competition: excess capacity and the markup.- Excess Capacity: Firms produce on the downward-sloping portion of their ATC curve in a monopolistic competition (Competitive firms produce at minimum of ATC.) o Efficient Scale: the point at which the quantity minimizes ATC. In the long run, monopolistically competitive firms produce below the efficient scale and perfectly competitive firms produce above it. (They produce below equilibrium, therefore, have excess capacity since in theory, they could produce more than they do.)o Excess Capacity: monopolistically competitive firms can increase the quantity they produce and lower the average total cost of production. However, firms choose not to do this because they would have to cut prices, so they operate with excess capacity. - Markup over Marginal Cost: Price exceeds marginal cost because the firm always has some market power in a monopolistically competitive market. Since marginalcost is below average total cost, and price equals average total cost, price must be above marginal cost. o An extra unit sold means more profit. Example: firms will send out Christmas cards to the buyers in order to gain a bigger customer base. Monopolistic Competition and the Welfare of Society - Inefficient aspects of monopolistic competition: o Some consumers who value a good at more than the marginal cost of production but less than the price won’t buy the good. Regulating firms that produce different products can be difficult; therefore, most of the time, policymakers decide it’s better to live with the inefficiency of monopolistic pricing. o There can be too many or not enough firms in the market because there is free entry. The 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. The business- stealing externality: Because other firms lose customers and profits from the entry of anew competitor, entry of anew firm imposes negative externalities on existing firms.- Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. The invisible hand doesn’t ensure that total surplus is maximized, but there is no easy way to fix inefficiency.Advertising - Firms that sell consumer goods spend 10%-20% on advertising, firms that sell industrial products spend less, and firms that sell homogeneous products (wheat) spend nothing at all.The Debate Over Advertising- The critique of advertising: Critics of advertising argue that firms advertise to manipulate people’s tastes. Advertising can be psychological rather than informative. It also increases the perception of product differentiation and brand loyalty, which makes consumers less concerned with the price differences of similar goods. Each firm charges a larger markup over marginal cost.- Defenders of advertising argue that firms use advertising to provide information to customers. This information allows customers to make better choices about what to buy, which allows markets to efficiently allocate resources. Advertising can also inform people about prices, which can lead them to make smarter decisions when purchasing goods. Policymakers have come to accept advertising as a way to provide information to customers and make markets more competitive. Advertising as a Signal of Quality- The willingness of a firm to spend a large amount of money on advertising can be a signal to customers about the quality of the product being offered. o If a firm is selling a low quality product, they will ultimately lose money ifthey advertise, and eventually, they’ll stop advertising their product. Firms that benefit from advertising will benefit from money spent in publicizing their product. Brand
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