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Chap 12: Monopolistic Competition


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1. Market Structures & Perfect Competition


Perfect Competition # firms Product Type Ease of Entry Many Identical High Wheat, Apples Monopolistic Competition Many Differentiated High DVDs, Restaurants Oligopoly Few Identical or differentiated Low Laptops, Cars Monopoly One Blocked Tap Water

CHAPTER 12: MONOPOLISTIC COMPETITION


Micro Recitation Torsten Jochem

Examples

Chap 12: Monopolistic Competition


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Chap 12: Monopolistic Competition


1. Market Structures & Perfect Competition
Differentiated means that the firm

Outline
1. Overview 2. Profit Maximization
2.1 in the Short Run 2.2 in the Long Run

Perfect Competition # firms Product Type Ease of Entry Examples Many Identical High Wheat, Apples

Monopolistic Competition Many Differentiated High DVDs, Restaurants

Oligopoly Monopoly is able to distinguish itself from other


firms selling similar products.

Few One Ex: 7Eleven vs. Starbucks Coffee


Take-out vs. Sit&Enjoy Coffee

3. Conclusions
3.1 Efficiency 3.2 Comparison: Perfect vs. Monopolistic Competition

Identical or This means: differentiated

Low but not identical Blocked product, it has


some pricing power over its good.

As a monopolistic firm sells a similar

Laptops, Cars

(The amount of pricing power depends on how much extra value the good gives to consumers compared to similar goods of competitors.)

Tap Water

Chap 12: Monopolistic Competition


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Chap 12: Monopolistic Competition


2. Profit Maximization
Recall methods for Profit Maximization:

1. Monopolistic Competition
price $4.00 SUPPLY $4.00 price

Starbucks

1. maximize (Revenue Total Costs) 2. Find output level where MR=MC (These two methods are the same in monopolistic competition as well as in perfect competition.)

$2.00

$2.00 DEMAND

$1.00

DEMAND quantity 250 millions 350 millions 450 millions Quantity 0 250,000 500,000

Complete Market for Coffee

Market Demand faced by Starbucks

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Chap 12: Monopolistic Competition


2. Profit Maximization (in the Short Run)

1. Monopolistic Competition
price price

Starbucks

As Starbucks offers a place to stay, SUPPLY work, listen to music, etc., it has some pricing power: it can demand a higher price (say, from $2 $4) $2.00 and still sell some of its coffee.
$4.00 $1.00 (This

price

Starbucks

# of Coffees
0 10,000 20,000

Price
Next:
$4.25 $4.00 $3.50 $3.00 $2.50 $2.00 $1.50

$4.00

$2.00 $4.00 DEMAND

30,000
DEMAND

is very different from perfect DEMAND competition, where a firm can only accept the market price!)
250 350 450 0 250,000 500,000

40,000 50,000 60,000

To find optimal output, compute MR curve, then add MC curve and see where MR=MC.

$2.00 quantity 0 10,000 50,000

Note 1: The more millions price power, the Quantity millions millions steeper the demand curve. Note 2: Trade-off: losing customers vs. Complete Market for higher price for remaining customers.

Coffee

Market Demand faced by Starbucks

Suppose this was the demand schedule of Starbucks.


(Note: while a firm can set the price, market forces (preferences, # of substitutes, etc.) determine how much will be sold at a given price.)

Chap 12: Monopolistic Competition


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Chap 12: Monopolistic Competition


2. Profit Maximization (in the Short Run)

2. Profit Maximization (in the Short Run)


price

Starbucks

# of Coffees
0 10,000 20,000

Price
$4.25 $4.00 $3.50 $3.00 $2.50 $2.00 $1.50

Total Rev.
$0 $40,000 $70,000 $90,000 $100,000 $100,000 $90,000

Marg. Rev.
$40,000 $30,000 $20,000 $10,000 $0 $-10,000

MR/Unit
price

Starbucks
MC per Unit ATC per Unit

$4.00 $1.50 $0.66 $0.25 $0.00 -$0.17


30,000 $4.00 $3.00 $2.50

Finally, adding the ATC curve we can determine the profits when output is 30,000:
($3.00-$2.50)*30,000 =$15,000. Note 1: 1. Under Perfect Competition, MR=p, as the firm cannot influence the price and since also MR= MC p = MC allocative efficiency. 2. Under Monopolistic Competition, p > MR and as MR=MC p > MC no allocative efficiency!

$4.00

30,000
DEMAND

40,000 50,000 60,000

Profits

DEMAND

$2.00

10,000

50,000 MR per Unit

Suppose this was the demand schedule of Starbucks.


(Note: while a firm can set the price, market forces (preferences, # of substitutes, etc.) determine how much will be sold at a given price.)

MR per Unit

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Chap 12: Monopolistic Competition


2. Profit Maximization (in the Short Run)

2. Profit Maximization (in the Short Run)


price

Starbucks
MC per Unit

$4.00 $3.00 DEMAND $2.00

# of Price Total Cakes Rev. Adding some MC curve $0 0 $4.25 and using the optimal 10,000 $4.00 $40,000 profit condition MR=MC, 20,000 $3.50 $70,000 we get the output level 30,000 $3.00 $90,000 that maximizes profit
40,000 30,000 $2.50 $100,000 and the price: $100,000 50,000 $2.00 60,000

Marg. Rev.
$40,000 $30,000 $20,000 $10,000 $0 $-10,000

MR/Unit
price

Starbucks
MC per Unit ATC per Unit

$4.00 $1.50 $0.66 $0.25 $0.00 -$0.17


30,000 $4.00 $3.00 $2.50

Note 2: 1. Under Perfect Competition, the firm produced where ATC was minimized, p = min ATC: productive efficiency. 2. Under Monopolistic Competition, firm produces where ATC is not minimized, p > min ATC: no productive efficiency!

Profits

DEMAND

10,000

30,000

50,000 MR per Unit

$3.00 $1.50 $90,000 for a total revenue of $90.000.

MR per Unit

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Chap 12: Monopolistic Competition


2. Profit Maximization (in the Long Run)
Starbucks
price

2. Profit Maximization (in the Short Run)


price

Starbucks
MC per Unit ATC per Unit

$4.00 $3.00 $2.50

Hence, in Monopolistic Competition we have in the SHORT-RUN:


1. No productive efficiency! 2. No allocative efficiency! 3. Profits for firms.

$4.00

The pricing power of the monopolistic firm erodes as new competitors enter, trying to copy the product to obtain a share of the profits.
DEMAND in Short Run

Profits

DEMAND

$2.00

30,000 0 MR per Unit 25,000 50,000

DEMAND in Long Run quantity

This means that at any given price, the firm will lose some of its customers to the new competitors. Hence, demand curve shifts left & gets more elastic

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Chap 12: Monopolistic Competition


2. Profit Maximization (in the Long Run)
Starbucks
price

2. Profit Maximization (in the Long Run)


Recall that we assumed that under monopolistic competition, entry into the market is easy.
Think of Starbucks; new competitors: McCafe, Cariboo,

Hence, as soon as profits occur: 1. Competitors enter market, copying the differentiated good to get a piece of the profits. 2. Supply of the differentiated good increases, lowering the overall market price. 3. Monopolistic firm loses its pricing power as the degree of differentiation of its good erodes.

$4.00

$2.00

As the demand curve shifts to the left and becomes more elastic, so does the Marginal Revenue DEMAND in Short Run (SR) curve.
DEMAND in Long Run (LR) 0 10,000 50,000 MR (SR) MR (LR) quantity

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Chap 12: Monopolistic Competition


2. Profit Maximization (in the Long Run)
price

2. Profit Maximization (in the Long Run)


Starbucks
price ATC MC $4.00 $3.00

Profits = $15,000
$2.50 DEMAND in Short Run (SR)

DEMAND in Long Run (LR) MR(SR)=MC 30,000 quantity MR (SR) MR (LR)

First, once again the Short Run: Step 1: Adding ATC, MC Step 2: See where MRSR=MC to find profit-max. output Step 3: Difference between price and ATC at output are the profits.

ATC MC $4.00

$2.00

DEMAND in Short Run (SR)

DEMAND in Long Run (LR) 0 MR(LR)=MC MR (SR) MR (LR) quantity

Long Run: When p=ATC and there are no more profits no more new firms enter the demand curve does not get more elastic any more but stays downward sloping. We will not get closer to the perfect competitive case any longer; instead this will be the long-run equilibrium outcome:

Chap 12: Monopolistic Competition


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Chap 12: Monopolistic Competition


2. Profit Maximization (in the Long Run)
price ATC MC $4.00

2. Profit Maximization (in the Long Run)


Starbucks
price ATC MC $4.00

$2.00

DEMAND in Short Run (SR)

DEMAND in Long Run (LR) 0 MR(LR)=MC MR (SR) MR (LR) quantity

Long Run: Step 1: Adding ATC, MC Step 2: See where MRLR=MC to find profit-max. output. Step 3: Gap b/w demand curve and ATC (=profit per unit) eroding. In long run, p = ATC! no profits! (Also, ATC is not minimized at output level.)

Hence, in Monopolistic Competition we have in the LONG-RUN:


1. p = ATC & ATC no minimized No productive efficiency! 2. p MC No allocative efficiency! 3. P = ATC No profits.

$2.00

DEMAND in Short Run (SR)

DEMAND in Long Run (LR) 0 MR(LR)=MC MR (SR) MR (LR) quantity

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Chap 12: Monopolistic Competition


3. Five Competitive Forces Model
Potential Entrants
(Threat from new Entrants)

2. Profit Maximization (in the Long Run)


If a monopolistic firm wants to preserve its profits
It must continuously innovate/improve its product so that the consumer perceives the good to have some greater value compared to the goods of competitors. This is good for consumers as the firm is seeking ways how to tailor its good closer and closer to the consumers tastes.

Suppliers
(Bargaining Power of Suppliers)

Industry Competitors
(Competition from existing Firms)

Buyers
(Bargaining Power of Buyers)

Substitutes
Competition from Substitute Goods

indicate where differentiation helps


against threats to profitability/competitiveness

Source: Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors, The Free Press, 1998

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Chap 12: Monopolistic Competition


3. How to Differentiate Products?
Marketing
Advertising
Making ones product attractive to customers Creating demand (i.e., new customer bases) Information about good comparisons.

3. How to Differentiate Products?


Profitability Market Factors Value
relative to competitors

Chance Events

Brand Management
Establishing some reputation e.g., quality, customer-service, price, Firms can establish trademarks, which grants legal protection against other firms using the product name Some brands have become so dominant that they represent the whole good types: Kleenex, Xerox, Band-Aid,

Differentiation

Cost Structure
relative to competitors

Source: Besanko et al., The Economics of Strategy, 4th ed., NY: Wiley, 2007.

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4. Perfect vs. Monopolistic Competition:
Perfect Competition Short Run profits Long Run profits Efficiency Firm Welfare Usually 0.
(Profits in SR possible during Demand/Supply Shocks)

4. Conclusions
1. Most businesses are in monopolistic competitive markets. 2. Monopolistic firms have short-run profits.
they can secure profits only if they continue to innovate, i.e. create extra value for consumers and thus keep their product differentiated from new entrants that try to copy the good.

Monopolistic Competition Yes

No
(since p = min ATC)

No
(since p = ATC) (Unless firm keeps differentiating)

3. Monopolistic firms have no long-run profits. 4. Monopolistic firms do not produce at lowest ATC: no productive efficiency. 5. Monopolistic firms sell at a price above MC: no allocative efficiency.

(a) productive: p=min ATC (b) allocative: p = MC LIFE IS TOUGH


(Firms can reap profits only during shocks.)

Neither productive nor allocative. LIFE IS TOUGH BUT REWARDING


(Incentives to always innovate.)

Consumer Welfare

LIFE IS GOOD

LIFE IS GOOD
(Can pay higher price if they see extra value, else not.)

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4. Conclusions (contd)
6. Are consumers worse off?
Despite (4) and (5), not necessarily, because: Consumers pay voluntarily a price higher than MC for a good which is not produced at lowest ATC. Instead of consuming this differentiated good (e.g., coffee from Starbucks), they still have the option to consume the non-differentiated good (e.g., coffee from diner/7Eleven). Hence, consumers can choose to benefit from a product that is differentiated/tailored towards their tastes/needs. Firms search for ways to create extra value for consumers by adapting their goods to fit the tastes of consumers.