Price-searcher markets with low entry barriers

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Monopolistic Competition
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CHAPTER
The Competitive Modelin a More Realistic Setting
Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market
How a Monopolistically Competitive Firm Maximizes Profit in the Short Run
What Happens to Profits in the Long Run?
Comparing Monopolistic Competition and Perfect Competition
How Marketing Differentiates Products
What Makes a Firm Successful?
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Monopolistic Competition
Characteristics

• Firms face low entry barriers
• Differentiated Products
• -they face a downward sloping demand curve
• -no Long Run Profits
• -Non-price Competition
• Price Taker
• Many Small Firms

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Product Differentiation

• Monopolistically competitive firms produce
  differentiated products products that differ in
  design, dependability, location, ease of
  purchase, etc.
• Rival firms produce similar products (good
  substitutes) and therefore each firm confronts a
  highly elastic demand curve.

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The Demand Curve for a Monopolistically
Competitive Firm
If a Starbucks increases prices, it will lose
some, but not all, of its customers. Here,
raising the price from 3.00 to 3.25 reduces the
quantity of caffè lattes sold from 3,000 to
2,400.
The Downward-Sloping Demand for Caffè Lattes at a
Starbucks
Therefore, unlike a perfect competitor, a
Starbucks store faces a downward-sloping demand
curve.
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McHits or McMisses?
Hulaburger - 1962
Filet o Fish - 1963
Strawberry shortcake - 1966
Big Mac - 1968
Big Mac
Big N Tasty
Big N Tasty w/ Cheese
Quarter Pounder w/ Cheese
Double Quarter Pounder w/ Cheese
Crispy Chicken
Chicken McGrill
Filet-O-Fish
Double Cheeseburger
Cheeseburger
Hamburger
Chicken McNuggets (4)
Chicken McNuggets (6)
Chicken McNuggets (9)
McSalad Shaker Chef Salad
McSalad Shaker Garden Salad
McSalad Shaker Grilled Chicken Caeser Salad
Hot Apple Pie - 1968
Egg McMuffin - 1975
Drive Thru - 1975
Chicken McNuggets - 1983
Extra Value Meal - 1991
McLean Deluxe - 1991
Arch Deluxe - 1996
55-cent Special - 1997
Big Xtra - 1999
McRib, Sundaes and others ??
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Double Jr. Cheeseburger Deluxe 1/4 lb. Single 1/2 lb. Double with Cheese 3/4 lb. Triple with Cheese
Baconator Jr. Hamburger Jr. Bacon Cheeseburger Jr. Cheeseburger Deluxe
Jr. Cheeseburger Double Stack Deluxe Double Stack Triple Stack
Fish Supreme Chicken Parmesan Sandwich 2/3 lb.
Monster Thickburger 1/3 lb. Low Carb
Thickburger Little Thick Cheeseburger 1/4 lb.
Little Thickburger 1/3 lb. Cheeseburger Chili
Cheese Thickburger 1/3 lb. Original
Thickburger 1/3 lb. Mushroom 'N' Swiss
Thickburger 1/3 lb. Bacon Cheese Thickburger
Big Chicken Fillet Sandwich Charbroiled Chicken
Club Sandwich Charbroiled BBQ Chicken Sandwich
Big Hot Ham 'N' Cheese Regular Hamburger
Regular Cheeseburger Double Cheeseburger
5-Piece Chicken Breast Strips 7-Piece Chicken
Breast Strips Big Shef
Homestyle Chicken Go Wrap Grilled Chicken Go Wrap Spicy Chicken Go Wrap Crispy Chicken Deluxe
Chicken Club Ultimate Chicken Grill Spicy Chicken Sandwich Homestyle Chicken Fillet
10-piece Chicken Nuggets Premium Fish Fillet Sandwich Crispy Chicken Sandwich
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Double Jr. Cheeseburger Deluxe 1/4 lb. Single 1/2 lb. Double with Cheese 3/4 lb. Triple with Cheese
Baconator Jr. Hamburger Jr. Bacon Cheeseburger Jr. Cheeseburger Deluxe
Jr. Cheeseburger Double Stack Deluxe Double Stack Triple Stack
Homestyle Chicken Go Wrap Grilled Chicken Go Wrap Spicy Chicken Go Wrap Crispy Chicken Deluxe
Chicken Club Ultimate Chicken Grill Spicy Chicken Sandwich Homestyle Chicken Fillet
10-piece Chicken Nuggets Premium Fish Fillet Sandwich Crispy Chicken Sandwich
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Price and Output

• A monopolistically competitive firm will expand
  output as long as marginal revenue exceeds
  marginal cost.
• Price will be lowered and output expanded until
  MR MC
• The price charged by the firm will be greater
  than its marginal cost.

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Marginal Revenue in Monopolistic Competition

• Initial price P1 output q1. Total revenue
  (TR) P1 q1.

Price
1. As price falls from P1 to P2, output
increases from q1 to q2, two conflicting
influences on TR.
P1
1. TR will rise because of an increase in the
number of units sold (q2 - q1) P2.
P2
2. TR will decline (P1 - P2) q1 as q1 units
once sold at the higher price (P1) are now sold
at the lower price (P2).
d

• Depending on the size of the shaded regions,
  total revenue may increase or decrease.

MR
Quantity/time
q2
q1
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Total Cost
Price (AR)
Marginal Cost
Output
Marginal Revenue
Total Revenue
Quantity
ATC
50 80 90 110 140 180 230 290 360 440 530
30 10 20 30 40 50 60 70 80 90
110 90 70 50 30 10 -10 -30 -50 -70
0 1 2 3 4 5 6 7 8 9 10
___
0 110 200 270 320 350 360 350 320 270 200
0 1 2 3 4 5 6 7 8 9 10
120 110 100 90 80 70 60 50 40 30 20
80 45 37 35 36 38 41 45 49 53
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What do these curves look like?
Price (AR)
Marginal Cost
Marginal Revenue
Quantity
ATC
30 10 20 30 40 50 60 70 80 90
110 90 70 50 30 10 -10 -30 -50 -70
0 1 2 3 4 5 6 7 8 9 10
120 110 100 90 80 70 60 50 40 30 20
80 45 37 35 36 38 41 45 49 53
How many to produce?
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120
110
Cost
100
90
80
70
60
50
40
30
20
10
0
6
7
8
9
10
3
4
5
1
2
Output
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120
110
Cost
100
MC
90
80
70
ATC
60
50
40
30
AR
20
MR
10
0
6
7
8
9
10
3
4
5
1
2
Output
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1. Firms profit maximizing output?
2. What price will they charge?
3. Firms revenue? Total Cost? Total Profit?
Price
4. How will things change in time?
MC
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ATC
10
8
D AR
MR
0
45
50
30
Quantity
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Price and Output Short Run Profit

• A monopolistic competitor maximizes profits by
  producing where MR MC, at output level q

MC
Price
and charges a price P along the demand curve for
that output level.
ATC
P

• At q the average total cost is C.

C

• What impact will economic profits have if this
  is a typical firm?

d

• Because the price is greater than the average
  total cost per unit (P gt C) the firm is
  making economic profits equal to the area ( P -
  C q )

MR
Quantity/time
q
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Profits and Losses in the Long Run

• Economic profits attract competition.
• New firms will expand supply and lower price.
• Individual demand curves will shift inward until
  the economic profits are eliminated.
• Economic losses cause firms to leave the market.
• Demand for the remaining firms output will rise
  until the losses have been eliminated, ending the
  incentive to exit.
• Firms can make either profits or losses in the
  short run, but only zero economic profit in the
  long run.

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Price and Output Long Run

• Because entry and exit are free, competition
  will eventually drive prices down to the level
  of ATC.

MC
Price

• When profits (losses) are present, the demand
  curve will shift inward (outward) until the
  zero profit equilibrium is restored.

ATC
P

• The price searcher establishes its output level
  where MC MR.

• At q the average total cost is equal to the
  market price. Zero economic profit is present.
  No incentive for firms to either enter or exit
  the market is present.

d
MR
Quantity/time
q
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Profits and Losses
Entry and Exit
Case 1 Prices rise
Profits
Entry or Exit?
Supply
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SR Profits
1. Increased Demand, Price goes up
2. Firms enter, Demand faced by each firm
decreases
Price
6
ATC
5
MC
4
SR Profits
3
Demand
2
3. Price goes down
1
4. No LR Profits
0
10
20
30
40
50
60
Quantity
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Profits and Losses
Entry and Exit
Case 2 Prices fall
Profits
Entry or Exit?
Supply
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SR Losses
1. Demand falls, Price goes down
2. Firms leave, Demand faced by each firm
increases
Price
6
ATC
5
MC
4
Demand
3
SR Losses
2
3. Price goes up
1
4. No LR Losses
0
10
20
30
40
50
60
Quantity
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The SR and the LR for a Monopolistically
Competitive Firm
Short Run Economic profit
Short Run P gt MC
Short Run Less elastic demand curve
Short Run P gt MC
or Economic loss
or P lt ATC
Long Run P gt MC
Long Run Zero economic profit
Long Run More elastic demand curve
Long Run P MC
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Comparing Competitive Markets

• LR equilibrium for both.
• P ATC and there are no economic profits.
• In monopolistic competition, firms face a
  downward-sloping demand curve, its
  profit-maximizing price exceeds MC.
• In Monopolistic Competition, output is too small
  to minimize ATC in long-run equilibrium.

MC
MC
ATC
ATC
P2
d
P1
d
MR
q1
q2
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Comparing Competitive Markets

• Even though the two markets have the same cost
  structure, the price in the monopolistic
  competitors market is higher than that in the
  price-takers market ( P2 gt P1 ).
• Some consider this price discrepancy a sign of
  inefficiency others perceive it as a premium
  society pays for variety and convenience (product
  differentiation).

Price
Price
MC
MC
ATC
ATC
P2
d
P1
d
MR
q1
q2
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Allocative Efficiency

• Allocative efficiency is achieved when the most
  desired goods are produced at the lowest possible
  cost.
• The Minimum point on the ATC curve
• ATC gt marginal cost at the minimum point
• No allocative efficiency in Monopolistic
  Competition.

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Product Differentiation (again)

• Monopolistically competitive firms produce
  differentiated products products that differ in
  design, dependability, location, ease of
  purchase, etc.

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Methods of Differentiation
Marketing All the activities necessary for a
firm to sell a product to a consumer. Brand
management The actions of a firm intended to
maintain the differentiation of a product over
time. Advertising If the increase in revenue
that results from advertising is greater than the
increase in costs, the firms profits will
rise. Defending a Brand Name A firm can apply for
a trademark, which grants legal protection
against other firms using its products name.
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What Makes a Firm Successful?
Ability to differentiate its product Producing
at a lower average cost than competing firms
Some profitability factors are not directly
under the firms control.
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13 Questions
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Right after you graduate, you get a job in
production management and you are responsible for
the entire company on weekends.
Here are the costs of production for the
company Quantity Average Total Cost
500 200 501 201
Your current level of production is 500 units and
all 500 have been ordered by regular customers.
One weekend, the phone rings. It is a customer
who wants to buy one unit of your product. This
means increasing production to 501 units. The
customer offers to buy it for 450.
Should you accept the offer?
What is the net change in the firms profit?
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Marginal Revenue ??
Marginal Cost ??
Quantity Average Total Cost 500 200
501 201
Total Cost (Q x ATC) 100,000 100,701
100,701 - 100,000 701
Marginal Cost 701
Marginal Revenue 450
Profit or Loss
Youre Fired!!!
L o s s
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In a monopolistically competitive market, the
firms will a. be able to choose their price,
and the entry barriers into the market will be
low. b. be able to choose their price, and the
entry barriers into the market will be high. c.
have to accept the market price for their
product, and the entry barriers into the market
will be low. d. have to accept the market price
for their product, and the entry barriers into
the market will be high.
A profit-maximizing monopolistically competitive
firm will expand output to the point where a.
total revenue equals total cost. b.
MR MC c. P ATC. d. P MC.
In the long run, neither perfectly competitive or
monopolistically competitive firms will be able
to earn economic profits because a. entry
barriers into these markets are high, raising the
costs of each firm. b. the government will
dictate moderate prices for these firms. c.
competition will force prices down to the level
of per-unit production costs. d. marginal
revenue is always less than marginal cost when
barriers to entry are low.
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If a market is in long-run equilibrium, which of
the following conditions will be present in a
perfectly competitive market but absent from a
monopolistically competitive market? a. P ATC
b. MR
MC c. P MC
d. MR lt P
As long as a market is contestable, then even if
it has only a few sellers, the a. threat of new
firms will prevent the prices from rising above
the competitive level. b. producers will be able
to charge prices that are high enough to produce
long-run economic profits. c. producers will not
face new competition because the barriers to
entry are high. d. market will never be expected
to come close to the competitive result.
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If firms in a monopolistically competitive market
are currently earning economic losses, then in
the long run, a. new firms will enter the
market, and the current firms will experience a
decrease in demand for their products until zero
economic profit is again restored. b. new firms
will enter the market, and the current firms will
experience an increase in demand for their
products until zero economic profit is again
restored. c. some existing firms will exit the
market, and the remaining firms will experience
an increase in demand for their products until
zero economic profit is again restored. d. some
existing firms will exit the market, and the
remaining firms will experience a decrease in
demand for their products until zero economic
profit is again restored.
Compared to the outcome when the firms are price
takers, monopolistically competitive markets will
result in a. a wider variety of products and
higher prices. b. less product variety and
higher prices. c. a wider variety of products
and lower prices. d. less product variety and
lower prices.
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What price should this monopolistically
competitive firm charge in order to maximize
profits?

1. 5 b. 7 c. 8 d. 10

d. 10
What is the maximum economic profit this firm
depicted in Figure 2 will be able to earn?
b. 20

1. 0 b. 20 c. 30 d. 100

If the cost and demand conditions of this
monopolistically competitive firm, what will
happen in the future?
a. Firms will go out of business, and the market
price will rise. b. The current market price will
tend to persist into the future. c. New firms
will enter the market, and demand facing this
firm will decline. d. The firms in this industry
probably will collude in order to increase their
profitability.