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PowerPoint Lecture Notes for Chapter 17: Monopolistic Competition Principles of Microeconomics 4th edition, by N.

Gregory Mankiw PowerPoint Slides by Ron Cronovich

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Monopolistic Competition

Examples of monopolistic competition are everywhere: the clothes students where, the frappacinos they slurp up on their way to class or work, the books they read, the nightclubs they dance at. As a result, students find the theory of monopolistic competition more relevant than the theory of perfect competition, which best describes produces like wheat and soybeans, products that few students every consider buying. If students are reasonably comfortable with the material on perfect competition and monopoly, then this chapter should not be difficult. It is also shorter than average.

PRINCIPLES OF

MICROECONOMICS
F OURT H E DITIO N

N. G R E G O R Y M A N K I W
PowerPoint Slides by Ron Cronovich
2007 Thomson South-Western, all rights reserved

In this chapter, look for the answers to these questions: How is monopolistic competition similar to perfect
competition? How is it similar to monopoly?

How do monopolistically competitive firms choose


price and quantity? Do they earn economic profit?

In what ways does monopolistic competition affect


societys welfare?

What are the social costs and benefits of


advertising?
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Introduction to Monopolistic Competition

Monopolistic competition:
a market structure in which many firms sell products that are similar but not identical.

Examples:

apartments books bottled water clothing fast food night clubs


MONOPOLISTIC COMPETITION 2

Another important dimension of product differentiation, not emphasized in the book, is location. Gasoline seems like an undifferentiated product, yet different gas stations charge different prices. How can some gas stations get away with charging 5 or even 10 cents more per gallon? The answer is product differentiation by location. Imagine youre driving home in rush-hour traffic from a grueling 10hour day at the office. The orange warning light comes on, indicating your car needs gas. After uttering a few choice expletives, you notice two gas stations at an upcoming intersection. The one on the right charges 5 cents more than the one on the left, but is easily accessible. The one on the left would require you to make a left-hand turn in heavy traffic to get into the station, and another to get out. And how much would you save? If you buy 20 gallons, youd save only $1. Alternatively, imagine you run a gas station located in a highly residential area, in which there are few other businesses including gas stations. If people want gas, they can buy it from you, or they can drive 10 minutes to a more commercial area with lots of gas stations. Your location allows you to charge a higher price. Business people have long understood that location is a critical dimension of product differentiation. Hence the saying location, location, location.

CHAPTER 17

Comparing Perfect & Monop. Competition


perfect competition number of sellers free entry/exit long-run econ. profits the products firms sell many yes zero identical monopolistic competition many yes zero differentiated

That long-run profits are zero follows from free entry/exit. The market power of a monopolistic competitor follows from the fact that it sells a product that is at least somewhat different from products sold by other firms.

firm has market power? none, price-taker yes D curve facing firm horizontal downwardsloping
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CHAPTER 17

MONOPOLISTIC COMPETITION

Comparing Monopoly & Monop. Competition


monopoly number of sellers free entry/exit long-run econ. profits firm has market power? D curve facing firm close substitutes
CHAPTER 17

monopolistic competition many yes zero yes

For monopolistic competition, free entry/exit drives profits to zero in the long run. In contrast, barriers to entry prevent the monopolists profits from being driven to zero. A monopoly is the sole seller of a product with no close substitutes. In contrast, the monopolistic competitor sells a product with many close substitutes. As a result, demand for the monopolists product is less elastic than demand for the monopolistic competitors product.

one no positive yes

downwarddownwardsloping sloping (market demand) none many


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MONOPOLISTIC COMPETITION

Comparing Oligopoly & Monop. Competition


oligopoly number of sellers few monopolistic competition many low high

importance of strategic high interactions between firms likelihood of fierce competition low

CHAPTER 17

MONOPOLISTIC COMPETITION

A Monopolistically Competitive Firm Earning Profits in the Short Run


The firm faces a downward-sloping D curve. At each Q, MR < P. To maximize profit, firm produces Q where MR = MC. The firm uses the D curve to set P.
CHAPTER 17 MONOPOLISTIC COMPETITION

The graphical analysis of the monopolistically competitive firms output, price, and profits/losses is very similar to that of the monopoly firm. One subtle difference is that the demand curve (and MR curve) facing the monopolistically competitive firm is likely to be flatter than the demand curve facing the monopolist, as the monopolistic competitor faces competition from other firms selling similar products.
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Price profit P ATC D MR Q Quantity MC ATC

A Monopolistically Competitive Firm With Losses in the Short Run


For this firm, P < ATC at the output where MR = MC. The best this firm can do is to minimize its losses.

Price MC losses ATC P D MR Q Quantity


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ATC

CHAPTER 17

MONOPOLISTIC COMPETITION

Monopolistic Competition and Monopoly

Short run: Under monopolistic competition,


firm behavior is very similar to monopoly.

Long run: In monopolistic competition,


entry and exit drive economic profit to zero.

If profits are in the short run: New firms enter market, taking some demand away from existing firms, prices and profits fall. If losses are in the short run: Some firms exit the market, remaining firms enjoy higher demand and prices.
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CHAPTER 17

A Monopolistic Competitor in the Long Run


Entry and exit occurs until P = ATC and profit = zero. Notice that the firm charges a markup of price over marginal cost, and does not produce at minimum ATC.
CHAPTER 17

Price MC ATC P = ATC markup D MC Q MR Quantity


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The level of output that minimizes ATC is greater than the output that maximizes the monopolistic competitors profits. Hence, we say the monopolistic competitor operates with excess capacity. (More on this topic on the next slide.)

MONOPOLISTIC COMPETITION

Why Monopolistic Competition Is Less Efficient than Perfect Competition


1. Excess capacity

The monopolistic competitor operates on the downward-sloping part of its ATC curve, produces less than the cost-minimizing output. Under perfect competition, firms produce the quantity that minimizes ATC.

Due to the markup of price over marginal cost, the market output under monopolistic competition will be smaller than the socially efficient output, as we discuss on the following slide.

2. Markup over marginal cost

Under monopolistic competition, P > MC. Under perfect competition, P = MC.


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CHAPTER 17

Monopolistic Competition and Welfare

Monopolistically competitive markets do not


have all the desirable welfare properties of perfectly competitive markets.

Because P > MC, the market quantity is below


the socially efficient quantity.

The problem facing policymakers here is similar to the problem arising from natural monopoly: With natural monopoly, ATC is always falling, so MC is below ATC. If regulators force a natural monopoly to price at marginal cost, it will incur losses.

Yet, not easy for policymakers to fix this problem:


Firms earn zero profits, so cannot require them to reduce prices.

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Monopolistic Competition and Welfare

Number of firms in the market may not be optimal,


due to external effects from the entry of new firms:

One of these externalities is positive, the other is negative. Its not clear which one is bigger, and it may in fact differ by industry.

the product-variety externality: surplus consumers get from the introduction of new products the business-stealing externality: losses incurred by existing firms when new firms enter market

The inefficiencies of monopolistic competition are


subtle and hard to measure. No easy way for policymakers to improve the market outcome.
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Advertising In monopolistically competitive industries,


product differentiation and markup pricing lead naturally to the use of advertising.

This section of the textbook has a nice FYI box contrasting the views on advertising of John Kenneth Galbraith and Frederic Hayek, two of the great economists of the 20th century.

In general, the more differentiated the products,


the more advertising firms buy.

Economists disagree about the social value of


advertising.

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The Critique of Advertising Critics of advertising believe: Society is wasting the resources it devotes to
advertising.

Firms advertise to manipulate peoples tastes. Advertising impedes competition it creates the perception that products are more differentiated than they really are, allowing higher markups.

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The Defense of Advertising


Defenders of advertising believe:

It provides useful information to buyers. Informed buyers can more easily find and exploit price differences. Thus, advertising promotes competition and reduces market power.

The study mentioned here was by economist Lee Benham, published in the Journal of Law and Economics in 1972. The textbook has a case study that discusses this research in more detail.

Results of a prominent study:


Eyeglasses were more expensive in states that prohibited advertising by eyeglass makers than in states that did not restrict such advertising.
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Advertising as a Signal of Quality


A firms willingness to spend huge amounts on advertising may signal the quality of its product to consumers, regardless of the content of ads .

Ads may convince buyers to try a product once, but the product must be of high quality for people to become repeat buyers. The most expensive ads are not worthwhile unless they lead to repeat buyers. When consumers see expensive ads, they think the product must be good if the company is willing to spend so much on advertising.
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CHAPTER 17

Brand Names
In many markets, brand name products coexist
with generic ones.

Firms with brand names usually spend more on


advertising, charge higher prices for the products.

As with advertising, there is disagreement about


the economics of brand names

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MONOPOLISTIC COMPETITION

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The Critique of Brand Names Critics of brand names believe: Brand names cause consumers to perceive
differences that do not really exist.

Consumers willingness to pay more for brand names is irrational, fostered by advertising. Eliminating govt protection of trademarks would reduce influence of brand names, result in lower prices.

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The Defense of Brand Names Defenders of brand names believe: Brand names provide information about quality
to consumers.

Companies with brand names have incentive to maintain quality, to protect the reputation of their brand names.

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CONCLUSION Differentiated products are everywhere;


examples of monopolistic competition abound.

The theory of monopolistic competition


describes many markets in the economy, yet offers little guidance to policymakers looking to improve the markets allocation of resources.

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CHAPTER SUMMARY A monopolistically competitive market has


many firms, differentiated products, and free entry.

Each firm in a monopolistically competitive market


has excess capacity produces less than the quantity that minimizes ATC. Each firm charges a price above marginal cost.

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CHAPTER SUMMARY Monopolistic competition does not have all of the


desirable welfare properties of perfect competition. There is a deadweight loss caused by the markup of price over marginal cost. Also, the number of firms (and thus varieties) can be too large or too small. There is no clear way for policymakers to improve the market outcome.

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CHAPTER SUMMARY Product differentiation and markup pricing lead to


the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to reduce competition and take advantage of consumer irrationality. Defenders argue that firms use them to inform consumers and to compete more vigorously on price and product quality.

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