What you will learn

in this chapter

 The meaning of monopolistic competition

 Why oligopolists and monopolistically competitive firms
differentiate their products
 How prices and profits are determined in monopolistic
competition in the short run and the long run
 Why monopolistic competition poses a trade-off between
lower prices and greater product diversity
 The economic significance of advertising and
brand names

To Vid
eo
THE LANDSCAPE OF FIRMS
YOU ARE
HERE
Competition
Monopolistic Oligopoly
competition
Monopoly

More competition Less competition

(less price control) (more price control)

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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure
that’s a little like monopoly and a little like perfect
competition. Specifically:
 many competitors
 products similar but not identical
 free entry into and exit from the industry in
the long run

Restaurants: monopolistic competitors

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PRODUCT DIFFERENTIATION
Product differentiation plays a crucial role in
monopolistic competition.
Tacit collusion is almost impossible when there
are many producers.
Product differentiation is the only way these
firms can acquire some market power.

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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
PRODUCT DIFFERENTIATION
There are three important forms of product
differentiation:
Differentiation by style or type
sedans vs. SUVs
Differentiation by location
dry cleaner near home vs. cheaper dry cleaner far
away
Differentiation by quality
ordinary ($) vs. gourmet chocolate ($$$)
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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
PRODUCT DIFFERENTIATION
There are two important features of
industries with differentiated products.
Competition among sellers: Entry by more
producers reduces the quantity each existing
producer sells.
Value in diversity: Consumers gain from the
increased diversity of products.

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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
ECONOMICS IN ACTION
Any color, so long as it’s black
Ford’s strategy was to offer just one style of car,
which maximized his economies of scale but
made no concessions to differences in taste.
Alfred P. Sloan of GM challenged this strategy
by offering a range of car types, differentiated
by quality and price.
By the 1930s the verdict was clear: Customers
preferred a range of styles!
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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
A (BLACK) STYLE FOR EVERY OCCASION

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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
SHORT-RUN PROFIT MAXIMIZATION
Same profit maximizing rule as previously used:
1. Produce the Q at which MR = MC.
2. Like monopoly firms, set price according to demand.
Price, cost,
marginal revenue MC
This profit will attract
new entrants.
ATC

Z
P

Profit
ATC

This profit cannot last.

MR D
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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
LEARN BY DOING: v
PRACTICE QUESTION
To identify the profit-maximizing output for this firm in the
short run, this graph needs:
a) the market price identified.
b) the MR curve identified.
c) the AVC curve identified.
d) All of the answers are true.
e) Answers (b) and (c) are true.

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ADJUSTMENTS TO LONG-RUN
EQUILIBRIUM
New entrants mean fewer customers for the original
firms: Demand and MR shift left.
Price, cost, (Economic) profits fall to zero: Firms break even and
marginal revenue new entry stops. MC

ATC

P
P = ATC Profit
ATC

D
MR
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SHORT-RUN LOSSES
New exits mean more customers for the remaining
firms: Demand and MR shift right.
(Economic) profits fall to zero: Firms break even and
exits stop.
Price, cost, MC
marginal revenue

ATC

ATC
Loss
P = ATC

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THE LONG-RUN ZERO-PROFIT
EQUILIBRIUM
Price, cost,
marginal revenue

MC

Point of tangency

ATC

Z
PMC = ATCMC

DMC
MRMC
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ZERO PROFIT IN THE LONG RUN
If firms are earning economic profits, new
firms will want to enter the industry.
This will reduce the demand curve facing
each individual producer.
In the long run, each supplier will earn
normal profits, and price will equal ATC.

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COMPARING LR EQUILIBRIUM IN PC AND
MC
(b) Long-run equilibrium in
(a) Long-run equilibrium in monopolistic competition
perfect competition
Price, cost,
Price, cost,
marginal
marginal
revenue
revenue MC ATC MC ATC

PMC = ATCMC

PPC = MCPC = D= MR = PPC

ATCPC
MCMC
MRMC DMC
QPC Quantity QMC Quantity

Minimum-cost output Minimum-cost output

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IS MONOPOLISTIC COMPETITION
INEFFICIENT?
Firms in a monopolistically competitive industry
have excess capacity: They produce less than the
output at which average total cost is minimized.

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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
IS MONOPOLISTIC COMPETITION
INEFFICIENT?
Price > MC, so some mutually beneficial trades
are unexploited.

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IS MONOPOLISTIC COMPETITION
INEFFICIENT?

Is the
higher
price worth
the extra diversity
of product
differentiation? Back to Ta
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THE ECONOMICS OF ADVERTISING
Oligopolies and monopolistically
competitive firms advertise.
Is advertising good or bad? Yes.
(There are different types of advertising.)

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ECONOMICS IN ACTION
THE PERFUME INDUSTRY:
LEADING CONSUMERS BY THE
NOSE
Only 3% of a perfume bottle’s cost is
ingredients… the rest is marketing and
packaging.
Studies show that people identify their
favorite scents based on ego and
branding… and often dislike the same
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TYPES OF ADVERTISING
Advertising as part of the product:
Even if NO information is given, does “branding” make
the product more enjoyable?
Tasters enjoy the cola more if it’s labeled “Coke”…

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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
TYPES OF ADVERTISING
“Informative” advertising:
price, quality and availability information

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ECONOMICS IN ACTION
THE HOUSING BUST AND THE DEMISE OF THE
6% COMMISSION
Real estate agents look a lot like Monopolistic Competitors…
except that they collected a high price that never changed (6%
commission)
Why?
• They controlled the MLS (Multiple Listing Service)
• They refused to work with discounters
What has changed?
• Justice department sued the national
agents’ group
• Housing crash forced commissions down
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
TYPES OF ADVERTISING
Advertising as Signaling

“If they’re spending so

much $$$ on advertising
for this product, they must
expect it to be profitable
and around a long time.
Must be good.”

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LEARN BY DOING: APPLICATION VIDEO
In this engaging TED talk, Rory Sutherland makes the daring
assertion that a change in perceived value can be just as satisfying as
what we consider “real” value—and his conclusion has interesting
consequences for how we look at life. (16 minutes)

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LEARN BY DOING: PRACTICE QUESTION

In your opinion, is advertising

“worth it” for society?
a) Yes
b) No

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LEARN BY DOING: BUSINESS CASE

GILETTE VERSUS SCHICK: A CASE

OF RAZOR BURN?
Competitive razor launches and their
huge advertising budgets: are they worth
it?
Do you pay more for the innovation of the
Hydro5, Fusion Pro-Glide with FlexBall TM
?
Or are you joining the Dollar Shave Club?
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C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S