CHAPTER 13A After studying this chapter you will be able to

Define and identify monopolistic competition

Explain how output and price are determined in a
Monopolistic Competition monopolistically competitive industry
Explain why advertising costs are high in a
monopolistically competitive industry

PC War Games What Is Monopolistic Competition?

Globalization brings enormous diversity in products and Monopolistic competition is a market with the following
thousands of firms seek to make their own product special characteristics:
and different from the rest of the pack.
ƒ A large number of firms.
Dell, Hewlett-Packard, Lenovo, Acer, and Toshiba
accounted for one half of the global market of $60 million ƒ Each firm produces a differentiated product.
PCs in 2006. ƒ Firms compete on product quality, price, and marketing.
Firms in these markets are neither price takers like those in ƒ Firms are free to enter and exit the industry.
perfect competition, nor are they protected from
competition by barriers to entry like a monopoly.
How do such firms choose the quantity to produce and
price?

What Is Monopolistic Competition? What Is Monopolistic Competition?

Large Number of Firms Product Differentiation

The presence of a large number of firms in the market Firms in monopolistic competition practice product
implies: differentiation, which means that each firm makes a
ƒ Each firm has only a small market share and therefore product that is slightly different from the products of
has limited market power to influence the price of its competing firms.
product.
ƒ Each firm is sensitive to the average market price, but no
firm pays attention to the actions of the other, and no
one firm’s actions directly affect the actions of other
firms.
ƒ Collusion, or conspiring to fix prices, is impossible.

1
What Is Monopolistic Competition? What Is Monopolistic Competition?

Competing on Quality, Price, and Marketing Entry and Exit

Product differentiation enables firms to compete in three
areas: quality, price, and marketing.
Quality includes design, reliability, and service.
Because firms produce differentiated products, each firm
has a downward-sloping demand curve for its own
product.
But there is a tradeoff between price and quality.
Differentiated products must be marketed using
advertising and packaging.
There are no barriers to entry in monopolistic competition,
so firms cannot earn an economic profit in the long run.
Examples of Monopolistic Competition
Figure 13.1 on the next slide shows market share of the
largest four firms and the HHI for each of ten industries
that operate in monopolistic competition.

What Is Monopolistic Competition?

Figure 13.1
shows examples.
ƒ The 4 largest
firms.
ƒ Next 4 largest
firms.
ƒ Next 12 largest
firms.
The numbers are
the HHI.

Price and Output in Monopolistic Price and Output in Monopolistic

Competition Competition

The Firm’s Short-Run Output and Price Decision

Figure 13.2 shows a
A firm that has decided the quality of its product and its short-run equilibrium for a
marketing program produces the profit-maximizing firm in monopolistic
quantity at which its marginal revenue equals its marginal competition.
cost (MR = MC).
It operates much like a
Price is set at the highest price the firm can charge for the single-price monopoly.
profit-maximizing quantity.
The price is determined from the demand curve for the
firm’s product.

2
 Price and Output in Monopolistic
Competition

The firm produces the

quantity at which marginal
revenue equals marginal
cost
and sells that quantity for
the highest possible price.
It makes an economic
profit (as in this example)
when P > ATC.

Price and Output in Monopolistic

Competition

Profit Maximizing Might

be Loss Minimizing
A firm might incur an
economic loss in the short
run.
Here is an example.
In this case, P < ATC.

Price and Output in Monopolistic Price and Output in Monopolistic

Competition Competition

Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
And entry continues as long as firms in the industry make
an economic profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition
maximizes its profit by producing the quantity at which its
marginal revenue equals its marginal cost, MR = MC.
As firms enter the industry, each existing firm loses some
of its market share. The demand for its product decreases
and the demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which
MR = MC and lowers the maximum price that the firm can
charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC and
firms earn zero economic profit.

3
Price and Output in Monopolistic
Competition

Figure 13.4 shows a firm

in monopolistic
competition in long-run
equilibrium.
If firms incur an economic
loss, firms exit to achieve
the long-run equilibrium.

Price and Output in Monopolistic Price and Output in Monopolistic

Competition Competition

Monopolistic Competition and Perfect Competition

Two key differences between monopolistic competition Excess Capacity
and perfect competition are:
Firms in monopolistic
ƒ Excess capacity competition operate with
ƒ Markup excess capacity in long-
run equilibrium.
A firm has excess capacity if it produces less than the
quantity at which ATC is a minimum. The downward-sloping
demand curve for their
A firm’s markup is the amount by which its price exceeds
its marginal cost. products drives this result.

Price and Output in Monopolistic

Competition

Markup
Firms in monopolistic
competition operate with
positive mark up.
Again, the downward-
sloping demand curve for
their products drives this
result.

4
 Price and Output in Monopolistic
Competition

In contrast, firms in perfect

competition have no
excess capacity and no
markup.
The perfectly elastic
demand curve for their
products drives this result.

Price and Output in Monopolistic

Competition

Is Monopolistic Competition Efficient

Because in monopolistic competition P > MC, marginal
benefit exceeds marginal cost.
So monopolistic competition seems to be inefficient.
But the markup of price above marginal cost arises from
product differentiation.
People value variety but variety is costly.
Monopolistic competition brings the profitable and possibly
efficient amount of variety to market.

Product Development and Marketing Product Development and Marketing

Innovation and Product Development Profit-Maximizing Product Innovation

We’ve looked at a firm’s profit-maximizing output decision Innovation is costly, but it increases total revenue.
in the short run and the long run of a given product and
with given marketing effort. Firms pursue product development until the marginal
revenue from innovation equals the marginal cost of
To keep making an economic profit, a firm in monopolistic innovation.
competition must be in a state of continuous product
development.
New product development allows a firm to gain a
competitive edge, if only temporarily, before competitors
imitate the innovation.

5
Product Development and Marketing Product Development and Marketing

Efficiency and Product Innovation Advertising

Firms in monopolistic
Marginal social benefit of an innovation is the increase in
competition incur heavy
the price that people are willing to pay for the innovation. advertising expenditures.
Marginal social cost is the amount that the firm must pay Figure 13.6 shows
to make the innovation. estimates of the
percentage of sale price
Profit is maximized when marginal revenue equals
for different monopolistic
marginal cost. competition markets.
In monopolistic competition, price exceeds marginal Cleaning supplies and
revenue, so the amount of innovation is probably less than toys top the list at almost
efficient. 15 percent.

ATC AFC AVC

Manufacturer (Asia)
Materials 9.00 9.00
Cost of labor 2.75 2.75
Cost of capital 3.00 3.00
Profit 1.75 1.75
Shipping 0.50 0.50
Import duties 3.00 3.00
Nike (Beaverton, Oregon)
Sales, distribution, and administration 5.00 5.00
Advertising 4.00 4.00
Research and development 0.25 0.25
Nike's profit 6.25 6.25
Retailer (your town)
Sales clerks wages 9.50 9.50
Shop rent 9.00 9.00
Retailers other costs 7.00 7.00
Retailer's profit 9.00 9.00
Totals $70.00 $6.50 $63.50

Product Development and Marketing Product Development and Marketing

Selling Costs and Total Costs Advertising costs might

Selling costs, like advertising expenditures, fancy retail lower the average total
buildings, etc. are fixed costs. cost by increasing
equilibrium output and
Average fixed costs decrease as production increases, so spreading their fixed costs
selling costs increase average total costs at any given over the larger quantity
level of output but do not affect the marginal cost of produced.
production.
Here, with no advertising,
Selling efforts such as advertising are successful if they the firm produces 25 units
increase the demand for the firm’s product. of output at an average
total cost of $60.

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Product Development and Marketing

The advertising
expenditure shifts the
average total cost curve
upward.
With advertising, the firm
produces 100 units of
output at an average total
cost of $40.
The firm operates at a
higher output and lower
average total cost than it
would without advertising.

Product Development and Marketing

Selling Costs and

Demand
In Figure 13.8(a), with no
advertising, demand is not
very elastic and the markup
is large.
In Figure 13.8(b),
advertising makes demand
more elastic, increases the
quantity and lowers the
price and markup.

Product Development and Marketing

Using Advertising to Signal Quality

Why do Coke and Pepsi spend millions of dollars a month
advertising products that everyone knows?
One answer is that these firms use advertising to signal
the high quality of their products.
A signal is an action taken by an informed person or firm
to send a message to uninformed persons.

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Product Development and Marketing Product Development and Marketing

For example,
Coke is a high quality cola and Oke is a low quality cola.
If Coke spends millions on advertising, people think “Coke
must be good.”
If it is truly good, when they try it, they will like it and keep
buying it.
If Oke spends millions on advertising, people think “Oke
must be good.”
If it is truly bad, when they try it, they will hate it and stop
buying it.
So if Oke knows its product is bad, it will not bother to
waste millions on advertising it.
And if Coke knows its product is good, it will spend
millions on advertising it.
Consumers will read the signals and get the correct
message.
None of the ads need mention the product. They just need
to be flashy and expensive.

THE END