Econ-301-ch-8

Monopolistic Competition: Key Conditions

An industry is monopolistically competitive if: 1. There are many buyers and sellers. 2. Each firm in the industry produces a differentiated product. 3. There is free entry into and exit from the industry.

Profit-maximizing advertising-to-sales ratio is:

𝐴/𝑅=𝐸_(𝑄,𝐴)/(−𝐸_(𝑄,𝑃) )

Implications of Entry Barriers

1 A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits. 2. Implication: monopoly profits will continue over time provided the monopoly maintains its market power. 3. Monopoly power, however, does not guarantee positive profits.

Output Rule

1 A profit-maximizing monopolist should produce the output, 𝑄^𝑀, such that marginal revenue equals marginal cost: 2. 𝑀𝑅(𝑄^𝑀 )=𝑀𝐶(𝑄^𝑀 )

Multiplant Output Rule

1 Let 𝑀𝑅(𝑄) be the marginal revenue of producing a total of 𝑄=𝑄_1+𝑄_2 units of output. 2. Suppose the marginal cost of producing 𝑄_1 units of output in plant 1 is 〖𝑀𝐶〗_1 (𝑄_1 ) and that of producing 𝑄_2 units in plant 2 is 〖𝑀𝐶〗_2 (𝑄_2 ). 3. The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that: 𝑀𝑅(𝑄)=〖𝑀𝐶〗_1 (𝑄_1 ) 𝑀𝑅(𝑄)=〖𝑀𝐶〗_2 (𝑄_2 )

Consider a monopolist producing output at two plants:

1 The cost of producing 𝑄_1 units at plant 1 is 𝐶(𝑄_1 ), and the cost of producing 𝑄_2 at plant 2 is 𝐶(𝑄_2 ). 2. When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is 𝑃(𝑄), where 𝑄=𝑄_1+𝑄_2.

Monopoly and Monopoly Power

1. A market structure in which a single firm serves an entire market for a good that has no close substitutes. 2. Sole seller of a good in a market gives that firm greater market power than if it competed against other firms.

Short-Run Output Decision

1. A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs. 2. Operating results in a smaller loss than ceasing operations.

Two strategies monopolistically competitive firms use to persuade consumers:

1. Comparative advertising 2. Niche marketing

Decision rule:

1. Continue operating as long as 𝑃≥𝐴𝑉𝐶 2. If 𝑃<𝐴𝑉𝐶, the firm should shut down its plant to minimize it losses.

How much should a firm spend on advertising to maximize profits?

1. Depends, in part, on the nature of the industry. 2. The optimal amount of advertising balances the marginal benefits and marginal costs.

Sources of Monopoly Power

1. Economies of scale 2. Economies of scope 3. Cost complementarity 4. Patents and other legal barriers

Short run losses leads to exit.

1. Exit decreases market supply, drives up the market price. 2. Losses are reduced.

Marginal Revenue and Linear Demand

1. Given an linear inverse demand function 2. 𝑃(𝑄)=𝑎+𝑏𝑄 3. where 𝑎>0 𝑎𝑛𝑑 𝑏<0, the associated marginal revenue is 4. 𝑀𝑅(𝑄)=𝑎+2𝑏𝑄

Pricing Rule

1. Given the level of output, 𝑄^𝑀, that maximizes profits, the monopoly price is the price on the demand curve corresponding to the 𝑄^𝑀 units produced: 2. 𝑃^𝑀=𝑃(𝑄^𝑀 )

Long-Run Competitive Equilibrium

1. In the long run, perfectly competitive firms produce a level of output such that 2. 𝑃=𝑀𝐶 Socially efficient output 3. 𝑃=𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝐴𝐶 Efficient plant size 4. Zero economic profits Firms are earning just enough to offset their opportunity cost.

Why Government Dislikes Monopoly?

1. Monopolists set price above marginal cost 2. 𝑃>𝑀𝐶 3. Too little output at too high price

Absence of a Supply Curve

1. Recall, firms operating in perfectly competitive markets determine how much output to produce based on price (𝑃=𝑀𝐶). 2. Thus, a supply curve exists in perfectly competitive markets.

Arguments for Monopoly

1. The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power. 2. Encourages innovation.

Competitive Firm's Demand

1. The demand curve for a competitive firm's product is a horizontal line at the market price. This price is the competitive firm's marginal revenue. 2. 𝐷^𝑓=𝑃=𝑀𝑅

Short-Run Output Decisions

1. The short run is a period of time over which some factors of production are fixed. 2. To maximize short-run profits, managers must take as given the fixed inputs (and fixed costs), and determine how much output to produce by changing the variable inputs.

Long Run Adjustments

1. There are no barriers to entry in perfectly competitive industry 2. Profits attract firms to enter the industry 3. Losses make firms to exit the industry

Profit-Maximization Rule

1. To maximize profits, a monopolistically competitive firm produces where its marginal revenue equals marginal cost. 2. The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the profit-maximizing level of output. 3. The profit-maximizing output, 𝑄^∗, is such that 𝑀𝑅(𝑄^∗ )=𝑀𝐶(𝑄^∗ ) and the profit-maximizing price is 𝑃^∗=𝑃(𝑄^∗ ).

Competitive Output Rule

1. To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing. 2. 𝑃=𝑀𝐶(𝑄)

Implication:

1. market demand curve is the monopolist's demand curve. 2. However, a monopolist does not have unlimited market power.

Profit-Maximizing Rule

1. 𝜋=𝑇𝑅−𝑇𝐶 2. To maximize 𝜋, set 𝑑𝜋/𝑑𝑄=0 3. 𝑑𝜋/𝑑𝑄=𝑑𝑇𝑅/𝑑𝑄−𝑑𝑇𝐶/𝑑𝑄=𝑀𝑅−𝑀𝐶=0 4. 𝑀𝑅=𝑀𝐶- To maximize profit, a competitive firm should produce

Long-Run Equilibrium

If firms in monopolistically competitive markets earn short-run 1. profits, additional firms will enter in the long run to capture some of those profits. 2. losses, some firms will exit the industry in the long run.

A key difference between monopolistically competitive and perfectly competitive markets is that each firm produces a slightly differentiated product.

Implication: products are close, but not perfect, substitutes; therefore, firm's demand curve is downward sloping under monopolistic competition.

Often a monopolist produces output in different locations.

Implications: manager has to determine how much output to produce at each plant.

Long-Run and Monopolistic Competition

In the long run, monopolistically competitive firms produce a level of output such that: 1. 𝑃>𝑀𝐶 2. 𝑃=𝐴𝑇𝐶>𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠

Short run profits leads to entry.

Short run profits leads to entry. 1. Entry increases market supply, drives down the market price. 2. Profits are reduced.

Implications of Product Differentiation

The differentiated nature of products in monopolistically competitive markets implies that firms in these industries must continually convince consumers that their products are better than their competitors.

Firm's Short-Run Supply Curve

The short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the 𝐴𝑉𝐶 curve.

A monopolist's market power implies 𝑃>𝑀𝑅=𝑀𝐶.

Thus, there is no supply curve for a monopolist, or in markets served by firms with market power.