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stic Competition
16
MONOPOLISTIC
COMPETITION
WHAT
’
S NEW IN THE
SEVENTH EDITION:
There are no major changes to this
chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students
should understand:
?
what market
structures lie between monopoly and competition.
?
competition among firms that sell
differentiated products.
?
how the
outcomes under monopolistic competition and under
perfect competition compare.
?
the
desirability of outcomes in monopolistically
competitive markets.
?
the debate over
the effects of advertising.
?
the debate over
the role of brand names.
CONTEXT AND PURPOSE:
Chapter 16 is the fourth chapter in a
five-chapter sequence dealing with firm behavior
and the
organization of industry. The
previous two chapters developed the two extreme
forms of market
structure
—
competition and monopoly. The market
structure that lies between competition and
monopoly is known as imperfect
competition. There are two types of imperfect
competition
—
monopolistic
competition and oligopoly. This chapter addresses
monopolistic competition
while the
final chapter in the sequence addresses oligopoly.
The analysis in this chapter is
again
based on the cost curves developed in Chapter 13.
The purpose of Chapter 16
is to address
monopolistic
competition
—
a market
structure in
which many firms sell
products that are similar but not identical.
Monopolistic competition
differs from
perfect competition because each of the many
sellers offers a somewhat different
product. As a result, monopolistically
competitive firms face a downward-sloping demand
curve
while competitive firms face a
horizontal demand curve at the market price.
Monopolistic
competition is extremely
common.
KEY POINTS:
?
?
A
monopolistically competitive market is
characterized by three attributes: many firms,
differentiated products, and free
entry.
The long-run equilibrium in a
monopolistically competitive market differs from
that in a
perfectly competitive market
in two related ways. First, each firm in a
monopolistically
competitive market has
excess capacity. That is, it chooses a quantity
that puts it on the
downward-sloping
portion of the average-total-cost curve. Second,
each firm charges a price
above
marginal cost.
?
Monopolistic competition does not have
all of the desirable properties of perfect
competition.
There is the standard
deadweight loss of monopoly caused by the markup
of price over
marginal cost. In
addition, the number of firms (and thus the
variety of products) can be
too large
or too small. In practice, the ability of
policymakers to correct these inefficiencies
is limited.
?
The product
differentiation inherent in monopolistic
competition leads to the use of
advertising and brand names. Critics of
advertising and brand names argue that firms use
them to manipulate
consumers
’
tastes and to
reduce competition. Defenders of advertising
and brand names argue that firms use
them to inform consumers and to compete more
vigorously on price and product
quality.
CHAPTER OUTLINE:
I.
Between Monopoly and
Perfect Competition
A.
The typical firm has some market power,
but its market power is not as great as that
described by monopoly.
B.
Firms in imperfect
competition lie somewhere between the competitive
model and the
monopoly model.
C.
Definition of
oligopoly: a market structure in which
only a few sellers offer similar or
identical products.
1.
Economists
measure a market
’
s
domination by a small number of firms with a
statistic called a
concentration ratio
.
2.
The
concentration ratio is the percentage of total
output in the market supplied by
the
four largest firms.
3.
In the U.S. economy, most industries
have a four-firm concentration ratio under
50%.
D.
Definition of
monopolistic
competition: a market structure in which many
firms sell
products that are similar
but not identical.
1.
Characteristics of
Monopolistic Competition
a.
Many Sellers
b.
Product Differentiation
c.
Free Entry
Figure 1
E.
Figure 1 summarizes the
four types of market structure. Note that it is
the number of
firms and the type of
product sold that distinguishes one market
structure from
another.
Draw a table with the four types of
markets across the top. Create rows for various
market characteristics such as type of
product sold, number of firms, control over
price, freedom of entry and exit, and
ability to earn profit in the long run. Students
will then be able to see how these
characteristics relate to one another.
Type:
In-class
assignment
Topics:
Market structure
Materials
needed:
None
Time:
15 minutes
Class limitations:
Works in any size class
Purpose
This assignment
helps students relate the concept of market
structure to the real world.
Instructions
Ask the class
to answer the following questions. After they have
answered all of them, ask the
students
to share their answers with a neighbor. Ask the
neighboring student to evaluate the
answer to the last question. List the
four market structures on the board and ask for
examples that fit each category
1.
Write the
name of a specific firm. It should be a real
company, not hypothetical.
2.
What products or services
does this firm sell? If the firm sells a wide
variety of goods,
choose a single item
to answer the following questions.
3.
What other firms compete
with this company? Are there many competitors,
only a few,
or none?
4.
Do the competing firms
sell exactly the same product or does each company
produce
goods with special
characteristics?
5.
Categorize the industry
as one of the following market structures:
a. Perfect competition
—
many firms
—
identical products
b. Monopoly
—
one firm
—
unique product
c. Oligopoly
—
a few firms
—
standard or differentiated
product
d. Monopolistic competition
—
many firms
—
differentiated
products
Activity
1
—
Think of a Firm
Common Answers and Points for
Discussion
Many students will choose
companies that produce consumer goods, where
product
differentiation is the most
important characteristic. Most of these industries
are either
oligopolies or
monopolistically competitive. A few students may
have examples of monopoly,
particularly
utilities or patented medicines. Almost no one
will give an example of perfect
competition.
Perfect competition, while an economic
ideal, does not accurately describe all sectors of
the
economy. Explaining that perfect
competition is a special case (and adding some
examples of
competitive industries)
will help students understand why competitive
firms face a horizontal
demand curve
and have no control over the prices of their
products.
Some students may
have questions about the differences between
oligopoly and monopolistic
competition.
Differentiating between a “few” and “many” is not
always easy. Measures of
market
concentration can be used to explain the
difference between these two imperfectly
competitive market structures.
II.
Competition with Differentiated
Products
A.
The
Monopolistically Competitive Firm in the Short Run
1.
Each firm in
monopolistic competition faces a downward-sloping
demand curve
because its product is
different from those offered by other firms.
2.
The
monopolistically competitive firm follows a
monopolist's rule for maximizing
profit.
Explain to students that product
differentiation gives the seller in a
monopolistically
competitive market
some ability to control the price of its product.
In a sense, each
firm is a monopoly in
the production of its particular version of the
product. This is
reflected by the fact
that these firms face a downward-sloping demand
curve. Point
out that the
graph looks something like a monopoly, but that
the demand the firm
faces
will likely be much flatter (because it will be
more elastic).
a.
It chooses the output
level where marginal revenue is equal to marginal
cost.
b.
It sets
the price using the demand curve to ensure that
consumers will demand
exactly the
amount produced.
Figure 2
3.
We can determine whether or not the
monopolistically competitive firm is earning a
profit or loss by comparing price and
average total cost.
a.
If
P
>
ATC
, the firm is earning a
profit.
b.
If
P
<
ATC
, the firm is earning a
loss.
c.
If
P
=
ATC
, the firm is earning
zero economic profit.
B.
The Long-Run Equilibrium
1.
When firms in
monopolistic competition are making profit, new
firms have an
incentive to enter the
market.
a.
This
increases the number of products from which
consumers can choose.
b.
Thus, the demand curve faced by each
firm shifts to the left.
c.
As the demand falls, these firms
experience declining profit.
2.
When firms in
monopolistic competition are incurring losses,
firms in the market
will have an
incentive to exit.
a.
Consumers will have fewer products from
which to choose.
b.
Thus, the demand curve
for each firm shifts to the right.
c.
The losses of the
remaining firms will fall.
3.
The process of exit and
entry continues until the firms in the market are
earning
zero profit.
a.
This means that the
demand curve and the average-total-cost curve are
tangent
to each other.
b.
At this point, price is
equal to average total cost and the firm is
earning zero
economic profit.
Figure 3
Remember that students have a hard time
understanding why a firm will continue to
operate if it is earning “only” zero
economic profit. Remind them that zero economic
profit means that firms are earning an
accounting profit equal to their implicit costs.
Point out to students that,
just like firms in perfect competition, firms in
monopolistic
competition also earn zero
economic profit in the long run. Show them that
this
result occurs because firms can
freely enter the market when profits occur,
driving
the level of profits to zero.
Any market with no barriers to entry will see zero
economic profit in the long run.
4.
There are two
characteristics that describe the long-run
equilibrium in a
monopolistically
competitive market.
a.
Price exceeds marginal
cost (due to the fact that each firm faces a
downward-
sloping demand curve).
b.
Price equals
average total cost (due to the freedom of entry
and exit).
C.
Monopolistic versus Perfect Competition
a.
The quantity of output
produced by a monopolistically competitive firm is
smaller than the quantity that
minimizes average total cost (the efficient
scale).
b.
This
implies that firms in monopolistic competition
have excess capacity,
because the firm
could increase its output and lower its average
total cost of
production.
c.
Because firms in perfect
competition produce where price is equal to the
minimum average total cost, firms in
perfect competition produce at their
efficient scale.
2.
Markup over Marginal Cost
a.
In
monopolistic competition, price is greater than
marginal cost because the firm
has some
market power.
b.
In perfect competition, price is equal
to marginal cost.
D.
Monopolistic Competition and the
Welfare of Society
1.
One source of inefficiency is the
markup over marginal cost. This implies a
deadweight loss (similar to that caused
by monopolies).
2.
Because there are so many firms in this
type of market structure, regulating these
firms would be difficult.
3.
Also, forcing these firms
to set price equal to marginal cost would force
them out of
business (because they are
already earning zero economic profit).
4.
There are also
externalities associated with entry.
Figure 4
1.
Excess Capacity
a.
The
product-variety
externality
occurs because as new firms
enter, consumers
get some consumer
surplus from the introduction of a new product.
Note that
this is a positive
externality.
b.
The
business-stealing
externality
occurs because as new firms
enter, other firms
lose customers and
profit. Note that this is a negative externality.
c.
Depending on
which externality is larger, a monopolistically
competitive market
could have too few
or too many products.
5.
In the News: Insufficient Variety as a
Market Failure
a.
Firms may insufficiently
service consumers with unusual preferences in
markets
with large fixed costs
b.
This article
from
Slate
describes how
some consumers get left out of the market
because of the high fixed costs
associated with creating additional varieties of a
product.
III.
Advertising
A.
The Debate over Advertising
1.
The Critique of
Advertising
a.
Firms advertise to manipulate people's
tastes.
b.
Advertising impedes competition because
it increases the perception of product
differentiation and fosters brand
loyalty. This means that consumers will be less
concerned with price differences among
similar goods.
2.
The Defense of Advertising
a.
Firms use advertising to
provide information to consumers.
b.
Advertising fosters
competition because it allows consumers to be
better
informed about all of the firms
in the market.
3.
Case Study: Advertising and the Price
of Eyeglasses
a.
In the United States during the 1960s,
states differed on whether or not they
allowed advertising for optometrists.
b.
In the states
that prohibited advertising, the average price
paid for a pair of
eyeglasses in 1963
was $$33; in states that allowed advertising, the
average price
was $$26 (a difference of
more than 20%).
B.
Advertising as a Signal of Quality
1.
The
willingness of a firm to spend a large amount of
money on advertising may be a
signal to
consumers about the quality of the product being
offered.
2.
Example: Kellogg and Post have each
developed a new cereal that would sell for $$3
per box. (Assume that the marginal cost
of producing the cereal is zero.) Each
company knows that if it spends $$10
million on advertising, it will get one million
new consumers to try the product. If
consumers like the product, they will buy it
again.
a.
Post has discovered through market
research that its new cereal is not very good.
After buying it once, consumers would
not likely buy it again. Thus, it will only
earn $$3 million in revenue, which would
not be enough to pay for the advertising.
Therefore, it does not advertise.
b.
Kellogg knows
that its cereal is great. Each person that buys it
will likely buy
one box per month for
the next year. Therefore, its sales would be $$36
million,
which is more than enough to
justify the advertisement.
c.
By its willingness to
spend money on advertising, Kellogg signals to
consumers
the quality of its cereal.
3.
Note that the
content of the advertisement is unimportant; what
is important is that
consumers know
that the advertisements are expensive.
C.
Brand Names
1.
In many markets there are
two types of firms; some firms sell products with
widely
recognized brand names while
others sell generic substitutes.
2.
Critics of brand names
argue that they cause consumers to perceive
differences that
do not really exist.
3.
Economists
have defended brand names as a useful way to
ensure that goods are of
high quality.
a.
Brand names
provide consumers with information about quality
when quality
cannot be judged easily in
advance of purchase.
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