Monopolistic Competition: Conomics

Seventh Edition
The Big Picture

Principles of
Economics  Chapter 13: The cost of production
Wojciech Gerson (1831-1901)

N. Gregory Mankiw  Now, we will look at firm’s revenue
 But revenue depends on market structure
1. Competitive market (chapter 14)
2. Monopoly (chapter 15)
CHAPTER Monopolistic 3. Monopolistic Competition (this chapter)
16 Competition
4. Oligopoly (chapter 17)
 Are there other types of markets?
 Yes, but not for now
Modified by Joseph Tao-yi Wang

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
1
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Seventh Edition
Summary
Principles of
Economics • For a firm in a perfectly competitive market,
price = marginal revenue = average revenue.

N. Gregory Mankiw
• If P > AVC, a firm maximizes profit by producing
the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.
• If P < ATC, a firm will exit in the long run.
CHAPTER Perfect
Monopolistic • In the short run, entry is not possible, and an
14 Competition increase in demand increases firms’ profits.
• With free entry and exit, profits = 0 in the long
run, and P = minimum ATC.
Seventh Edition
Perfect Competition
Principles of
 Products are Perfect Substitutes Economics

 Result: Price Taking N. Gregory Mankiw
 P = MR = MC
 SR: Will operate if P > AVC (FC is sunk)
 LR: Will operate at P = ATC CHAPTER
 Firms enter if P > ATC; exit if P < ATC Monopoly
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
4 Modified by Joseph Tao-yi Wang
Summary Summary
• A monopoly firm is the sole seller in its market. • Monopoly firms maximize profits by producing
Monopolies arise due to barriers to entry, the quantity where marginal revenue equals
including: government-granted monopolies, the marginal cost. But since marginal revenue is
control of a key resource, or economies of scale less than price, the monopoly price will be
over the entire range of output. greater than marginal cost, leading to a
• A monopoly firm faces a downward-sloping deadweight loss.
demand curve for its product. As a result, it • Monopoly firms (and others with market power)
must reduce price to sell a larger quantity, which try to raise their profits by charging higher prices
causes marginal revenue to fall below price. to consumers with higher willingness to pay.
This practice is called price discrimination.
Summary Monopoly
• Policymakers may respond by regulating  MR=MC to maximize profit (still true!)
monopolies, using antitrust laws to promote
 But, P > MR (D - downward sloping)
competition, or by taking over the monopoly and
running it. Due to problems with each of these  Welfare Cost of a Monopoly:
options, the best option may be to take no  Profits (unfair?) vs. DWL (efficiency loss!)
action.
 Cures? Do nothing?
• Or, just auction off the market. (Demsetz, 1968)  Auction off the market!
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Seventh Edition In this chapter,

look for the answers to these questions
Principles of
Economics • What market structures lie between perfect
N. Gregory Mankiw competition and monopoly, and what are their

characteristics?
• How do monopolistically competitive firms choose
price and quantity? Do they earn economic profit?
CHAPTER Monopolistic • How does monopolistic competition affect society’s

welfare?
16 Competition • What are the social costs and benefits of
advertising?

INTRODUCTION: Characteristics & Examples of Monopolistic
Between Monopoly and Competition Competition
Two extremes Characteristics:
 Perfect competition (perfect substitutes): many  Many sellers
firms, identical products  Product differentiation
 Monopoly (no close substitutes): one firm  Location, location, location! (產品定位)
 Free entry and exit
In between these extremes: imperfect competition Examples:
 Oligopoly: only a few sellers offer similar or  apartments
identical products.  books
 Monopolistic competition: many firms sell  bottled water
similar but not identical products.  clothing
 fast food
= Partial Substitutes!  night clubs
12 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
13
Comparing Perfect & Monop. Competition Comparing Monopoly & Monop. Competition
Perfect Monopolistic Monopolistic
Monopoly
competition competition competition
number of sellers one many
number of sellers many many
free entry/exit no yes
free entry/exit yes yes
long-run econ. profits zero zero long-run econ. profits positive zero
the products firms sell identical differentiated firm has market power? yes yes
firm has market power? none, price-taker yes downward-

downward-
D curve facing firm sloping
downward- sloping
D curve facing firm horizontal (market demand)
sloping
close substitutes none many
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A Monopolistically Competitive Firm Earning A Monopolistically Competitive Firm

Profits in the Short Run With Losses in the Short Run
The firm faces a For this firm,
downward-sloping P < ATC
D curve. Price Price
MC at the output where MC
profit
At each Q, MR < P. MR = MC.
P ATC losses ATC
To maximize profit, The best this firm
ATC ATC
firm produces Q can do is to
D P
where MR = MC. minimize its losses.
MR D
The firm uses the
D curve to set P. MR
Q Quantity Q Quantity
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Monopolistic Competition and Monopoly A Monopolistic Competitor in the Long Run
 Short run: Under monopolistic competition, Entry and exit

firm behavior is very similar to monopoly. occurs until
 Long run: In monopolistic competition,
P = ATC and Price
entry and exit drive economic profit to zero. profit = zero. MC
 If profits in the short run: Notice that the ATC
New firms enter market, firm charges a P = ATC
taking some demand away from existing firms, markup of price
markup
prices and profits fall. over marginal cost
 If losses in the short run: D
and does not MC
Some firms exit the market, produce at MR
remaining firms enjoy higher demand and prices. minimum ATC. Q Quantity
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Why Monopolistic Competition Is

Monopolistic Competition and Welfare
Less Efficient than Perfect Competition
1. Excess capacity  Monopolistically competitive markets do not
have all the desirable welfare properties of
 The monopolistic competitor operates on the
perfectly competitive markets.
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.  Because P > MC,
 Under perfect competition, firms produce the market quantity < socially efficient quantity.
quantity that minimizes ATC.  Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
2. Markup over marginal cost to reduce prices.
 Under monopolistic competition, P > MC.
 Under perfect competition, P = MC.
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Monopolistic Competition and Welfare

ACTIVE LEARNING 1
Advertising
 Number of firms in the market may not be optimal,
due to external effects from the entry of new firms: 1. So far, we have studied three market structures:
 The product-variety externality: perfect competition, monopoly, and monopolistic
surplus consumers get from the introduction competition. In each of these, would you expect
of new products to see firms spending money to advertise their
 The business-stealing externality: products? Why or why not?
losses incurred by existing firms 2. Is advertising good or bad from society’s
when new firms enter market viewpoint? Try to think of at least one “pro” and
 The inefficiencies of monopolistic competition are “con.”
subtle and hard to measure. No easy way for
policymakers to improve the market outcome.
Advertising The Critique of Advertising
 In monopolistically competitive industries,  Critics of advertising believe:
product differentiation and markup pricing  Society is wasting the resources it devotes to
lead naturally to the use of advertising. advertising.
 In general, the more differentiated the products,  Firms advertise to manipulate people’s tastes.
the more advertising firms buy.  Advertising impedes competition—it creates the
 Economists disagree about the social value of perception that products are more differentiated
advertising. than they really are, allowing higher markups.
25
The Defense of Advertising Advertising as a Signal of Quality

 Defenders of advertising believe: A firm’s willingness to spend huge amounts
 It provides useful information to buyers. on advertising may signal the quality of its product
to consumers, regardless of the content of ads.
 Informed buyers can more easily find and
exploit price differences.  Ads may convince buyers to try a product once,
but the product must be of high quality for people
 Thus, advertising promotes competition and
to become repeat buyers.
reduces market power.
 The most expensive ads are not worthwhile
 Results of a prominent study: Benham (1972) unless they lead to repeat buyers.
Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers  When consumers see expensive ads,
than in states that did not restrict such advertising. they think the product must be good if the company
is willing to spend so much on advertising.
27
Brand Names The Critique of Brand Names

 In many markets, brand name products coexist  Critics of brand names believe:
with generic ones.  Brand names cause consumers to perceive
 Firms with brand names usually spend more on differences that do not really exist.
advertising, charge higher prices for the products.  Consumers’ willingness to pay more for brand
names is irrational, fostered by advertising.
 As with advertising, there is disagreement about
 Eliminating govt protection of trademarks
the economics of brand names…
would reduce influence of brand names,
result in lower prices.
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The Defense of Brand Names CONCLUSION
 Defenders of brand names believe:  Differentiated products are everywhere;
 Brand names provide information about quality examples of monopolistic competition abound.
to consumers.  The theory of monopolistic competition
 Companies with brand names have incentive describes many markets in the economy,
to maintain quality, to protect the reputation of yet offers little guidance to policymakers looking
their brand names. to improve the market’s allocation of resources.
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Summary Summary
• A monopolistically competitive market has • Monopolistic competition does not have all of the
many firms, differentiated products, and free desirable welfare properties of perfect
entry. competition. There is a deadweight loss caused
• Each firm in a monopolistically competitive by the markup of price over marginal cost. Also,
market has excess capacity—it produces the number of firms (and thus varieties) can be
less than the quantity that minimizes ATC. too large or too small. There is no clear way for
Each firm charges a price above marginal cost. policymakers to improve the market outcome.
Summary Monopolistic Competition

• Product differentiation and markup pricing lead  Most close to reality
to the use of advertising and brand names.  Differentiated Products:
Critics of advertising and brand names argue  Location, location, location!
that firms use them to reduce competition and
 SR: Like a monopoly (locally)
take advantage of consumer irrationality.
Defenders argue that firms use them to inform  LR: Zero profits
consumers and to compete more vigorously on  Homework: Mankiw, Ch.16,
price and product quality. Problem 2, 5, 7, 8, 9, 10.
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Seventh Edition

The Big Picture

Wojciech Gerson (1831-1901)

Modified by Joseph Tao-yi Wang

price = marginal revenue = average revenue.

 Products are Perfect Substitutes Economics

 Result: Price Taking N. Gregory Mankiw

Seventh Edition In this chapter,

N. Gregory Mankiw competition and monopoly, and what are their

CHAPTER Monopolistic • How does monopolistic competition affect society’s

Modified by Joseph Tao-yi Wang

firm has market power? none, price-taker yes downward-

A Monopolistically Competitive Firm Earning A Monopolistically Competitive Firm

 Short run: Under monopolistic competition, Entry and exit

Why Monopolistic Competition Is

Monopolistic Competition and Welfare

The Defense of Advertising Advertising as a Signal of Quality

Brand Names The Critique of Brand Names

Summary Monopolistic Competition

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