Ch15 Monopolistic Competition

7/30/2019 Ch15 Monopolistic Competition

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When you have completed your study of thischapter, you will be able to

C H A P T E R C H E C K L I S T

Describe and identify monopolistic competition.1

Explain how a firm in monopolistic competitiondetermines its output and price in the short run andthe long run .

2

Explain why advertising costs are high and wy firmsuse brand names in monopolistic competition.

3


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15.1 WHAT IS MONOPOLISTIC COMPETITION?

Monopolistic competition is a market structure inwhich:

A large number of independent firms compete.

Each firm produces a differentiated product.

Firms compete on product quality, price, andmarketing.

Firms are free to enter and exit.


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Large Number of Firms

Like perfect competition, the market has a large number

of firms. Three implications are:

Small market share

No market dominance

Collusion impossible



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Product Differentation

Product differentiation

Making a product that is slightly different from the

products of competing firms.

A differentiated product has close substitutes but it does

not have perfect substitutes.

When the price of one firms product rises, the quantity

demanded of that firms product decreases.



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Competing on Quality, Price, and Marketing

Quality

Design, reliability, service, ease of access to theproduct.

Price

A downward sloping demand curve.

Marketing

Advertising and packaging



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Entry and Exit

No barriers to entry.

A firm cannot make economic profit in the long run.



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Identifying Monopolistic Competition

Two indexes:

The four-firm concentration ratio The Herfindahl-Hirschman Index



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The four-firm concentration ratio

The percentage of the value of sales accounted for by

the four largest firms in the industry.The range of concentration ratio is from almost zero for

perfect competition to 100 percent for monopoly.

A ratio that exceeds 40 percent: indication of

oligopoly. A ratio of less than 40 percent: indication of

monopolistic competition.



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The Herfindahl-Hirschman Index (HHI)

The square of the percentage market share of each firmsummed over the largest 50 firms in a market.

Example, four firms with market shares as 50 percent,25 percent, 15 percent, and 10 percent.

HHI = 502 + 252 + 152 + 102 = 3,450

A market with an HHI less than 1,000 is regarded ascompetitive.

An HHI between 1,000 and 1,800 is moderatelycompetitive.



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Limitations of Concentration Measures

The two main limitations of concentration measuresalone as determinants of market structure are theirfailure to take proper account of

The geographical scope of a market

Barriers to entry and firm turnover



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15.2 OUTPUT AND PRICE DECISIONS

How, given its costs and the demand for its jeans, does

Tommy Hilfiger decide the quantity of jeans to produce

and the price at which to sell them?

The Firms Profit-Maximizing Decision

The firm in monopolistic competition makes its output

and price decision just like a monopoly firm does.

Figure 15.1 on the next slide illustrates this decision.


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1. Profit is maximizedwhen MR = MC

3.The profit-maximizingprice is $75 per pair.

4. The firm makes aneconomic profit of

$6,250 a day.

2. The profit-maximizingoutput is 125 pairs ofTommy jeans per day.

ATC is $25 per pair, so



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Profit Maximizing Might Be Loss Minimizing

Some firms in monopolistic competition have a tough

time making a profit.

A burst of entry into an industry can limit the demand for

each firms own product.

Figure 15.1 on the next slide illustrates a firm incurring a

loss in the short run.


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1. Loss minimized whenMC = MR

3.The price is $40 permonth, which is lessthan ATC.

4. The firm incurs aneconomic loss.

2. The loss-minimizingoutput is 40,000customers.



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Long Run: Zero Economic Profit

Economic profit induces entry and economic lossinduces exit, as in perfect competition.

Entry decreases the demand for the product of eachfirm.

Exit increases the demand for the product of each firm.

In the long run, economic profit is competed away andfirms earn normal profit.

Figure 15.3 on the next slide illustrates long-runequilibrium.



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1. The output thatmaximizes profit is 75

pairs of Tommy jeans aday.

2. The price is $50 perpair. Average total cost

is also $50 per pair.

3. Economic profit iszero.



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Monopolistic Competition and PerfectCompetition

The two key differences between monopolisticcompetition and perfect competition are that in

monopolistic competition, there is

Excess capacity

A markup of price over marginal cost



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Excess Capacity

A firm has excess capacity if the quantity it produces

is less that the quantity at which average total cost is a

minimum.

A firms efficient scale is the quantity of production at

which average total cost is a minimum.

MarkupA firms markup is the amount by which price exceeds

marginal cost.



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1. The efficient scale is 100pairs of jeans a day.


2. The quantity produced isless than the efficient scaleand the firm has excess

capacity.3. Price exceeds marginal

cost by the amount of themarkup.


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In perfect competition, theefficient quantity is producedand price equals marginalcost.



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Is Monopolistic Competition Efficient

Efficiency requires marginal benefit to equal marginal cost.

In monopolistic competition, price exceeds marginal cost,which is an indicator of inefficiency.

Making the Relevant Comparison

Price exceeds marginal cost because of product

differentiation. But product variety is valued.The Bottom Line

The bottom line is ambiguous. But compared to thealternative, monopolistic competition looks efficient.



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15.3 DEVELOPMENT AND MARKETING

Innovation and Product Development

Wherever economic profits are earned, imitators

emerge.To maintain economic profit, a firm must seek out new

products.

Cost Versus Benefit of Product Innovation

The firm must balance the cost and benefit at the

margin.


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Efficiency and Product Innovation

Regardless of whether a product improvement is real or

imagined, its value to the consumer is its marginal

benefit, which equals the amount the consumer is

willing to pay.

The marginal benefit to the producer is the marginal

revenue, which in equilibrium equals marginal cost.

Because price exceeds marginal cost, product

improvement is not pushed to its efficient level.


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Advertising

Firms in monopolistic competition spend a large amount

on advertising and packaging their products.

Marketing Expenditures

A large proportion of the prices that we pay cover the

cost of selling a good.

Figure 15.5 on the next slide shows some estimates ofmarketing expenditures for some familiar markets.


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Selling Costs and Total Costs

Advertising expenditures increase the costs of a

monopolistically competitive firm above those of a

perfectly competitive firm or a monopoly.

Advertising costs are fixed costs.

Advertising costs per unit decrease as production

increases.Figure 15.6 on the next slide illustrates the effects of

selling costs on total cost.


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1. When advertisingcosts are added to . . .

2. the average totalcost of production,

3. average totalcost increases by agreater amount atsmall outputs thanat large outputs.


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4.If advertising enablessales to increase

from 25 pairs of jeansa day to 100 pairs aday, it lowers theaverage total costfrom $60 a pair to$40 a pair.


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Selling Costs and Demand

Advertising and other selling efforts change the demand

for a firms product.

The effects are complex:

A firms own advertising increases the demand for

its product

Advertising by all firms might decrease thedemand for any one firms product and make

demand more elastic.

The price and markup might fall.


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Figure 15.7 shows the

possible effect ofadvertising.

With no advertising,

demand is low but the

markup is large.


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With advertising, average

total cost increases and the

ATCcurve becomes ATC1.

Demand decreases and

becomes more elastic.

Profit maximizing outputincreases, the price falls,

and the markup shrinks.


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Using Advertising to Signal Quality

Some advertising is very costly and has almost no

information content about the item being advertised.

Such advertising is used to signal high quality.

A signal is an action taken by an informed person or

firm to send a message to uninformed people.

Signaling works because it is profitable to signal highquality and deliver it but unprofitable to signal a high

quality product and not deliver it.


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Brand Names

Brand names are also used to provide information

about the quality of a product.

It is costly to establish a widely recognized brand name.

Like costly advertising, a brand name signals high

quality.

Brand names work because it is unprofitable to incurthe cost of creating a brand name and then deliver a

low quality product.


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Efficiency of Advertising and Brand Names

Advertising and brand names that provide information

about the quality of products so that buyers are able to

make better choices can be efficient if the marginal cost

of the information equals its marginal benefit.

The final verdict on the efficiency of monopolistic

competition is ambiguous.

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Ch15 Monopolistic Competition

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