When you have completed your study of this chapter, you will be able to

1
(No Transcript)
2
C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

Describe and identify monopolistic competition.
Explain how a firm in monopolistic competition
determines its output and price in the short run
and the long run.
Explain why advertising costs are high and why
firms use brand names in monopolistic competition.
3
15.1 MONOPOLISTIC COMPETITION

• Monopolistic competition is a market structure in
  which
• A large number of independent firms compete.
• Each firm produces a differentiated product.
• Firms compete on product quality, price, and
  marketing.
• Firms are free to enter and exit.

4
15.1 MONOPOLISTIC COMPETITION

• Large Number of Firms
• Like perfect competition, the market has a large
  number of firms. Three implications are
• Small market share
• No market dominance
• Collusion impossible

5
15.1 MONOPOLISTIC COMPETITION

• Product Differentation
• Product differentiation
• Making a product that is slightly different from
  the products of competing firms.
• A differentiated product has close substitutes
  but it does not have perfect substitutes.
• When the price of one firms product rises, the
  quantity demanded of that firms product
  decreases.

6
15.1 MONOPOLISTIC COMPETITION

• Competing on Quality, Price, and Marketing
• Quality
• Design, reliability, service, ease of access to
  the product.
• Price
• A downward-sloping demand curve.
• Marketing
• Advertising and packaging.

7
15.1 MONOPOLISTIC COMPETITION

• Entry and Exit
• No barriers to entry.
• A firm cannot make economic profit in the long
  run.

8
15.1 MONOPOLISTIC COMPETITION

• Identifying Monopolistic Competition
• Two indexes
• The four-firm concentration ratio
• The Herfindahl-Hirschman Index

9
15.1 MONOPOLISTIC COMPETITION

• Four-firm concentration ratio
• The percentage of the value of sales accounted
  for by the four largest firms in the industry.
• The range of concentration ratio is from almost
  zero for perfect competition to 100 percent for
  monopoly.
• A ratio that exceeds 40 percent indication of
  oligopoly.
• A ratio of less than 40 percent indication of
  monopolistic competition.

10
15.1 MONOPOLISTIC COMPETITION

• Herfindahl-Hirschman Index (HHI)
• The square of the percentage market share of each
  firm summed over the largest 50 firms in a
  market.
• Example, four firms with market shares of 50
  percent, 25 percent, 15 percent, and 10 percent.
• HHI 502 252 152 102 3,450
• A market with an HHI less than 1,000 is regarded
  as competitive.
• An HHI between 1,000 and 1,800 is moderately
  competitive.

11
15.1 MONOPOLISTIC COMPETITION

• Output and Price in Monopolistic Competition
• Think about the decisions that Tommy Hilfiger
  must make about Tommy jeans.
• How, given its costs and the demand for its
  jeans, does Tommy Hilfiger decide the quantity of
  jeans to produce and the price at which to sell
  them?

12
15.1 MONOPOLISTIC COMPETITION

• The Firms Profit-Maximizing Decision
• The firm in monopolistic competition makes its
  output and price decision just like a monopoly
  firm does.
• Figure 15.1 on the next slide illustrates this
  decision.

13
15.1 MONOPOLISTIC COMPETITION
1. Profit is maximized when MC MR
2. The profit-maximizing output is 150 pairs of
Tommy jeans per day.
3. The profit-maximizing price is 70 per pair.
ATC is 20 per pair, so
4. The firm makes an economic profit of 7,500 a
day.
14
15.1 MONOPOLISTIC COMPETITION

• Long Run Zero Economic Profit
• Economic profit induces entry of new firms and
  economic loss induces exit of old firms, as in
  perfect competition.
• Entry decreases the demand for the product of
  each firm.
• Exit increases the demand for the product of each
  firm.
• In the long run, economic profit is competed away
  and firms earn normal profit.

15
15.1 MONOPOLISTIC COMPETITION
Figure 15.2 illustrates long-run equilibrium.
Tommy Hilfiger is producing 150 pairs of jeans a
day and making a profit of 7,500 a day.
This economic profit encourages new firms to
produce jeans.
16
15.1 MONOPOLISTIC COMPETITION
In the long run, the demand for Tommy jeans
decreases.
1. The output that maximizes profit decreases to
50 pairs of jeans a day.
2. The price is 30 per pair. Average total cost
is 30 per pair.
3. Economic profit is zero.
17
15.1 MONOPOLISTIC COMPETITION

• Monopolistic Competition and Efficiency
• Efficiency requires marginal benefit of the
  consumer to equal marginal cost of the producer.
• In monopolistic competition, price exceeds
  marginal cost, which is an indicator of
  inefficiency.
• Price exceeds marginal cost because of product
  differentiation. But product variety is valued.
• In the long run, firms in monopolistic
  competition always have excess capacity.

18
15.1 MONOPOLISTIC COMPETITION

• Excess Capacity
• A firms capacity output is the output at which
  average total cost is a minimum.
• Figure 15.3 shows that in the long run, the firm
  in monopolistic competition always produces less
  than its capacity output and so has excess
  capacity.

19
15.1 MONOPOLISTIC COMPETITION
In the long run,
1. The firm produces 50 pairs of jeans a day.
2. The quantity produced is less than the
capacity output.
3. In the long run, the firm operates with excess
capacity.
20
15.2 DEVELOPMENT AND MARKETING

• Innovation and Product Development
• Wherever economic profits are earned, imitators
  emerge.
• To maintain economic profit, a firm must seek out
  new products.
• Cost Versus Benefit of Product Innovation
• The firm must balance the cost and benefit at the
  margin.

21
15.2 DEVELOPMENT AND MARKETING

• Efficiency and Product Innovation
• Regardless of whether a product improvement is
  real or imagined, its value to the consumer is
  its marginal benefit, which equals the amount the
  consumer is willing to pay.
• The marginal benefit to the producer is the
  marginal revenue, which in equilibrium equals
  marginal cost.
• Because price exceeds marginal cost in
  monopolistic competition, product improvement is
  not pushed to its efficient level.

22
15.2 DEVELOPMENT AND MARKETING

• Marketing
• Firms in monopolistic competition spend a large
  amount on advertising and packaging their
  products.
• Marketing Expenditures
• A large proportion of the prices that we pay
  cover the cost of selling a good.
• Figure 15.4 on the next slide shows some
  estimates of marketing expenditures for some
  familiar markets.

23
15.2 DEVELOPMENT AND MARKETING
24
15.2 DEVELOPMENT AND MARKETING

• Selling Costs and Total Costs
• Advertising expenditures increase the costs of a
  monopolistically competitive firm above those of
  a perfectly competitive firm or a monopoly.
• Advertising costs are fixed costs.
• Advertising costs per unit decrease as production
  increases.
• Figure 15.5 on the next slide illustrates the
  effects of selling costs on total cost.

25
15.2 DEVELOPMENT AND MARKETING
1. When advertising costs are added to ...
2. the average total cost of production,
15.3 OLIGOPOLY
3. average total cost increases by a greater
amount at small outputs than at large outputs.
26
15.2 DEVELOPMENT AND MARKETING

• 4. If advertising enables sales to increase from
  25 pairs to 100 pairs a day, the average total
  cost falls from 60 a pair to 40 a pair.

27
15.2 DEVELOPMENT AND MARKETING

• Selling Costs and Demand
• Advertising and other selling efforts change the
  demand for a firms product.
• The effects are complex
• A firms own advertising increases the demand for
  its product.
• Advertising by all firms might increase the
  number of firms, decrease the demand for any one
  firms product, and make demand more elastic.

28
15.2 DEVELOPMENT AND MARKETING

• Efficiency The Bottom Line
• Some gains from extra product variety offset the
  selling costs and the extra cost arising from
  excess capacity, as in clothing, food, magazines
  industries.
• It is less easy to see the gains from being able
  to buy a brand-name drug that is identical to a
  generic alternative.
• The final verdict on the efficiency of
  monopolistic competition is ambiguous.

29
15.3 OLIGOPOLY

• Another market type that stands between perfect
  competition and monopoly.
• Oligopoly is a market type in which
• A small number of firms compete.
• Natural or legal barriers prevent the entry of
  new firms.

30
15.3 OLIGOPOLY

• In contrast to monopolistic competition and
  perfect competition, an oligopoly consists of a
  small number of firms.
• Each firm has a large market share
• The firms are interdependent
• The firms have an incentive to collude

31
15.3 OLIGOPOLY

• When a small number of firms compete in a market,
  they are interdependent in the sense that the
  profit earned by each firm depends on the firms
  own actions and the actions of the other firms.
• Before making a decision, each firm must consider
  how the other firms will react to its decision
  and influence its profit.

32
15.3 OLIGOPOLY

• Collusion
• When a small number of firms share a market, they
  can increase their profit by forming a cartel and
  acting like a monopoly.
• A cartel is a group of firms acting together to
  limit output, raise price, and increase economic
  profit.
• Cartels are illegal but they do operate in some
  markets.
• Despite the temptation to collude, cartels tend
  to collapse. (We explain why in the final
  section.)

33
15.3 OLIGOPOLY

• To study oligopoly, well start with a special
  case called duopoly.
• Duopoly is a market in which there are only two
  firms.
• Duopoly in Airplanes
• Airbus and Boeing are the only makers of large
  commercial jet aircraft.
• Figure 15.6 illustrates the market that Airbus
  and Boeing share.

34
15.3 OLIGOPOLY
35
15.3 OLIGOPOLY

• Competitive Outcome
• Price equals marginal cost.
• Monopoly Outcome
• The firm would be a single-price monopoly.
• Range of Possible Oligopoly Outcomes
• The extremes of perfect competition and monopoly
  provide the maximum range within which the
  oligopoly outcome might lie.

36
15.3 OLIGOPOLY
37
15.3 OLIGOPOLY

• Duopolists Dilemma
• By limiting production to the monopoly quantity,
  the firms can maximize joint profits.
• By increasing production, one firm might be able
  to make an even larger profit and force a smaller
  profit onto the other firm.

38
15.3 OLIGOPOLY

• If the two firms produce the monopoly output of 6
  airplanes a week, their joint profit can be 72
  million.

39
15.3 OLIGOPOLY
Boeing Increases Output to 4 Airplanes a Week

• Boeing can increase its economic profit by 4
  million and cause the economic profit of Airbus
  to fall by 6 million.

40
15.3 OLIGOPOLY

• Airbus Increases Output to 4 Airplanes a Week

For Airbus this outcome is an improvement on the
previous one by 2 million a week. For Boeing,
the outcome is worse than the previous one by 8
million a week.
41
15.3 OLIGOPOLY

• Boeing Increases Output to 5 Airplanes a Week

If Boeing increases output to 5 airplanes a week,
its economic profit falls.
Similarly, if Airbus increases output to 5
airplanes a week, its economic profit falls.
42
15.3 OLIGOPOLY

• A dilemma
• If both firms stick to the monopoly output, they
  both produce 3 airplanes and make 36 million.
• If they both increase production to 4 airplanes a
  week, they both make 32 million.
• If only one increases production to 4 airplanes a
  week, that firm makes 40 million.
• What do they do?
• Game theory provides an answer.