GE: Ch. 14 - Monopolistic Competition & Product Differentiation

Excess capacity

- Book definition: occurs when the firm produces below the level where ATC is minimized. - My definition: refers to a situation where a firm is producing at a lower scale of output than it has been designed for.

What Happens to Losses When Some Firms Exit?

- when firms are making economic losses, some firms will exit the industry. - as some firms exit, it means fewer firms in the market, which increases the demand for the remaining firms' product, shifting their DCs to the right, from DSR to DLR. - when firms exit not only will the firm's DC move outward, but it also becomes relatively more inelastic due to each firm's products having fewer substitutes (less choices for consumers). - the higher demand results in smaller losses for the existing firms until all losses finally disappear where the ATC curve is tangent to the DC.

The Impact of Many Sellers

- when many firms compete for the same customers, any particular firm has little control over or interest in what other firms do. - a restaurant may change prices or improve service w/o a retaliatory move on the part of other competing restaurants b/c there are so many rivals. - restaurants, drug stores, auto repair shops, and dry cleaners tend to act independently in metropolitan areas.

Achieving Long-Run Equilibrium

- when the market reaches this long-run equilibrium, no firms have an incentive to enter or exit. - once entry and exit have driven profits to zero, the DC and ATC will be tangent to each other. - at the profit-maximizing output level, the firm earns zero economic profits.

Three-Step Method for Monopolistic Competition

1. Find where marginal revenues = marginal costs and proceed straight down to the horizontal quantity axis to find q*, the profit-maximizing level. 2. At q*, go straight up to the DC and then to the left to find the market price, P*. Once you have identified P* and q*, you can find total revenue at the profit-maximizing output level b/c TR = P • q. 3. The last step is to find total costs. Again, go straight up from q* to the ATC curve, which reveals the ATC per unit. If we multiply ATCs by the output level, we can find the total costs (TC = ATC • q).

3 Basic Characteristics of Monopolistic Competition:

1. Product differentiation 2. Many sellers 3. Free entry

Product differentiation (Prestige)

Many people prefer to be seen using the currently popular brand, while others prefer the "off" brand. Particularly important w/ gifts -- Cub cigars, Mont-blanc pens, beluga caviar, Godiva chocolates, or Rolex watches.

Product differentiation (Physical differences)

for example, brands of ice cream (such as Dreyer's and Breyers) or fast-food Mexican restaurants (such as Taco Bell and Del Taco) differ significantly in taste to many buyers.

If total revenue is < total costs at q*,...

the firm is generating total economic losses.

If total revenue is > total costs at q*,...

the firm is generating total economic profits.

What are the Real Costs of Monopolistic Competition?

- Can we "fix" a monopolistically competitive firm to look more like an efficient, perfectly competitive firm? 1. One remedy might entail using a govt. regulation. 2. This process would be costly b/c a monopolistically competitive firm makes no economic profits in the long run. - the govt. would have to consequently subsidize the firm. - b/c there are so many monopolistically competitive firms, the administrative costs of regulation would be prohibitive. - regulation could also reduce the incentive these firms have to create what consumers want -- differentiated products. - b/c consumers value variety -- the ability to choose from competing products and brands -- the loss in efficiency must be weighted against the gain in increased product variety. - the gains from product diversity can be large and may easily outweigh the inefficiency costs.

Product differentiation

- G/S that are slightly different, or perceived to be different, from one another. - the significant feature of differentiation is the buyer's belief that various sellers' products are not the same, whether the products are actually different or not. 1. Physical Differences 2. Prestige 3. Location 4. Service

Monopolistic competition

- a market structure w/ many firms selling differentiated products. - For example, a restaurant is a monopoly in the sense that it has a unique name, menu, qualify of service, location, and so on, but it also has many competitors. - individual sellers in monopolistic competition believe that they have some market power. - the monopolistically competitive firm produces a product that is different (that is, differentiated rather than identical or homogenous) from others, which leads to some degree of monopoly power.

Why Do Firms Advertise?

- advertising is an important, non-price method of competition that is commonly used in industries where the firm has market power. - it would make little sense for a perfectly competitive firm to advertise its products. - firms that sell highly differentiated consumer products such as soft drinks, toothpastes, razor blades, and breakfast cereals can spend btwn 10 and 20% of their revenue on advertising. - firms that sell homogenous goods, such as wheat, rarely spend anything promoting their brands. - the purpose of advertising is to sell more of the good at the going price. - in perfect competition, the firm can sell all it wants at the going price. - only firms that have market power, and therefore charge a price above marginal cost, have an incentive to advertise to increase profits.

Advertising as a Signal of Quality

- an expensive ad on TV may signal to consumers that this product may come from a relatively large and successful company. 1. This is true when ads feature famous celebrities, so the celebrity endorsement/expensive advertising may send a signal that this is a quality product. - a nationally recognized brand name will provide consumers w/ confidence about the quality of its product. - the chain name may also send a signal to the buyer that the company expects repeat business, and therefore it has an important reputation to uphold. - it will also distinguish its product from others.

The Significance of Excess Capacity:

- b/c in monopolistic competition the DC is downward sloping, its point of tangency with the ATC curve will not and cannot be at the lowest level of average cost. - even when long-run adjustments are complete, firms are not operating at a level that permits the lowest average cost of production -- the efficient scale of the firm.

Determining Short-Run Equilibrium

- each firm in monopolistic competition is similar to the firm in the monopoly market, in that it regards its products as different from those offered by other firms and, thus, faces a downward-sloping DC. - the intersection of the marginal revenue and marginal cost curves indicates that the short-run profit-maximizing output will be q*. - by observing how much will be demanded at that output level, we find out profit-maximizing price, P*. - @ the equilibrium quantity, q*, we go vertically to the DC and read the corresponding price on the vertical axis, P*.

Product differentiation (Location)

- shoppers are not willing to travel long distances to purchase similar items, which is one reason for the large # of convenience stores and service station mini-marts. - most buyers realize brands of gasoline do not differ significantly, which means the location of a gas station might influence their choice of gasoline. - some restaurants can differentiate their products w/ beautiful views of the city lights, ocean, or mountains.

What is the Impact of Advertising on Society?

- some have argued that advertising manipulates consumer tastes and wastes billions of dollars annually, creating "needs" for trivial products. - critics argue that most advertising is psychological, trying to manipulate people's tastes, rather than informational. - advertising helps create a demonstration effect, whereby people have new urges to buy products previously unknown to them and perhaps creating a desire that may not have existed. - sometimes advertising is based on misleading claims, so people find themselves buying products that do not provide the satisfaction or results promised in the ads. - critics argue that advertising impedes competition, alters consumers' tastes, and may lead to "irrational" brand loyalty, but defenders believe it can increase competition and quality and often provides valuable product and service information.

Product differentiation (Service)

- speedy and friendly service or lenient return policies are important to many people. - speed and quality of service may significantly influence a person's choice of restaurants.

What Happens to Economic Profits When Firms Enter the Industry?

- the result of new firms entering to take advantage of the economic profits is more sellers of similar products, which means that each new firm will cut into the demand of the existing firms. 1. The DC for each of the existing firms will fall. - w/ entry, not only will the firm's DC move inward but it also becomes relatively more elastic due to each firm's products having more substitutes (more choices for consumers). - this decline in demand continues to occur until the ATC curve becomes tangent w/ the DC, and economic profits are reduced to zero.