Chapter 14 Monopolistic competition Monopolistic competition a market structure in which A large number of firms compete o Small market share Each firm supplies a small part of the total industry output Each firm has only limited power to influence the price of its product Because all firms are relatively small no one firm can dictate market conditions o Ignore other firms o Collusion impossible Collusion a fixed higher price Firms in monopolistic competition would like to be able to conspire to fix a higher price it is not possible Each firm produces a differentiated product o Product differentiation a product that is slightly different from the products of competing firms close substitute but not a perfect substitute Firms compete on product quality price and marketing o Quality o Price o Marketing Quality the physical attributes that make a product different from the products of other firms i e design reliability etc The firm can set both its price and its output A firm that makes a high quality product can charge a higher price than a for low quality product Monopolistic firms must market their product through advertising and packaging Firms are free to enter and exit the industry o No barriers to prevent new firm from entering the industry o A firm in monopolistic competition cannot make an economic profit in the long run The firm s shot run output and price decision In the short run a firm in monopolistic competition makes its output and price decision just like a monopoly firm does In order to maximize economic profit the firm produces the output at which marginal revenue equals marginal cost but charges the price on the demand curve Long run zero economic profit If an industry is doing well other firms will try to enter causing existing firms demand curves and marginal revenue curves shift leftward and decrease the price falls At equilibrium all firms in the industry make zero economic profit Monopolistic competition vs perfect competition Excess capacity o A firm has excess capacity if it produces below its efficient scale o Efficient scale the quantity at which average total cost is a minimum o Firms could sell more by cutting their prices but they would then incur losses i e there are usually empty tables at family owned restaurants Markup o Markup the amount by which price exceeds marginal cost o Does not happen in perfect competition Is monopolistic competition efficient Must compare it to something else The markup that drives a gap between price and marginal cost arises from product differentiation People value variety but it is costly The efficient degree of product variety is the one for which the marginal social benefit of product variety equals its marginal social cost Monopolistic competition may me efficient in comparison to product uniformity Innovation and product development Existing firms must constantly be prepared to compete with the prospect of new firms Firms must constantly innovate to separate themselves from the pack only temporary because soon after people will begin to make knock offs When the marginal cost and marginal revenue of product development are equal the firm is under taking the profit maximizing amount of product development Marginal social benefit of an innovation is the increase in price that consumers are willing to pay for it the marginal social cost is the amount that the firm must pay to make the innovation profit is maximized when marginal revenue equals marginal cost In monopolistic competition marginal revenue is less than price so product innovation is probably not efficient Advertising A large portion of the price that we pay for a good covers the cost of selling it and this proportion is increasing Advertising expenditures affect the profits of the firms in two ways they increase costs and they change demand o Selling costs and total cost Selling costs are fixed costs and they increase the firm s total cost Advertising costs per unit decrease as the quantity produced increases The total cost of advertising is fixed but the average cost of advertising decreases as output increases o Selling costs and demand Advertising increases demand Advertising informs people about the quality of its products and persuades people to buy their product But since all firms in monopolistic competition advertise advertising decreases the demand faced by any one firm Advertising can end up not only lowering average total cost but also lowering the markup and the price Signal an action taken by an informed person or firm to send a message to uninformed people An advertisement doesn t need any specific product information just needs to be expensive and hard to miss Using advertising to signal quality Brand names A brand name provides information to consumers about the quality of a product and is an incentive to the producer to achieve a high and consistent quality standard It is still unclear if monopolistic competition is efficient