Monopolistic Competition

Definitions and Descriptions of Monopolistic Competition Product Differentiation Identifying the Monopolistic Competitor Profit Maximization in Short-Run and Long-Run Price Discrimination Efficiency or Inefficiency Closing Thoughts

Monopolistic Competition

On one extreme is the Perfect Competition model On the other extreme is the Monopoly Model Monopolistic Competition & Oligopoly are competitive scenarios that lie between these two extremes Therefore, competitive features of Monopolistic Competition and Oligopoly will emulate either Perfect Competition or Monopoly
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Characteristics of Monopolistic Competition

Power to set prices somewhat like a monopoly Face competition like perfect competition ********************************************* Large number of firms -- Each firm has relatively small market share -- Each firm must be sensitive to average market price of its product -- Collusion is not possible due to the number of firms No barriers to entry or exit

Characteristics of Monopolistic Competition

Product Differentiation Each firm makes a product that is slightly different from the products of competing firms. -- Close substitutes but no perfect substitutes -- An attempt to increase price will normally results in a lower volume sold Competition on Quality, Price, Marketing -- Quality is design, reliability, service provided to buyer and ease of access to product -- Price downward sloping demand curve -- Marketing firm must market = promotion, distribution, packaging 3

Product Differentiation

Product differentiation is crucial to monopolistic competition People value variety, even if it is not material (real) Product differentiation takes place in buyers mind Americans are provided with a wide variety of products and services Variety is valued but costly we pay for it

The Typical Monopolistic Competitor

The monopolistic competitor tries to set his or her product apart from the competition The main way of doing this is through advertising

When this is done successfully, the demand curve becomes more vertical or inelastic Buyers are willing to pay more for a product or service because they believe it is much better than their other choices

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Basis for Product Differentiation

Physical differences Convenience Ambience Reputations Appeals to vanity Unconscious fears and desires Snob appeal Customized products

Product Differences

Product differentiation does not necessarily mean there are any physical differences among products

They might all be the same, but how they are sold may make all the difference

There are, of course, some very real physical product differences.

Buyers often differentiate based on real physical differences, but differentiation is still taking place in the buyers mind, and it may or may not be based on real physical differences

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Advertising and Branding

Whats to be gained by pouring money into advertising? It works! -- Continuous signals regarding product differentiation -- coca-cola vs pepsi Brand has tremendous value -- e.g. Budweiser -- Brands tend to capture in a single name all the values a firm wants to impress upon the buyer

The Typical Monopolistic Competitor

Tries to set his firm apart from his competition
-- New Product Development and Innovation 1. Striving to maintain an economic profit -- Advertising 1. Create consumer perception of product differentiation real or imagined 2. Attempting to keep demand as inelastic as possible Selling costs can be extremely high

Identifying Monopolistic Competition

How much is the industry dominated or not dominated by few suppliers -- geographical scope national, regional, global An industry can be almost perfectly competitive on a national scope, but almost a monopoly locally e.g. Concrete Mixing -- Barriers to entry and exit industries may appear concentrated but few barriers exist to prevent entry: e.g a community with only one restaurantthere is no barrier to other restaurants coming in
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Identifying Monopolistic Competition

The four-firm concentration ratio The percentage of the value of total market revenue accounted for by the four largest firms in the industry -- A low concentration ratio indicates a high degree of competition -- A high concentration ratio indicates an absence of competition

Identifying Monopolistic Competition

The Herfindahl-Hirschman Index the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50) -- In perfect competition, the HHI is small -- In monopoly, the HHI is 10,000 (100 squared) -- A popular measure with the Justice Dept in the 1980s HHI < 1000 characterized competitive markets HHI > 1800 would bring Justice Dept challenge to proposed mergers 6

Examples of Monopolistic Competition

Banks Radio Stations Clothing Computers Frozen Foods Canned Goods Sporting Goods Fish and Seafood Jewelry Health Spas Apparel Stores Convenience Stores

Monopolistic Competition

Since the Monopolistic Competitor prices at demand where MR=MC, the firm may have 1. excess production capacity, and is 2. operating below its efficient scale where ATC is minimum

Markup The amount by which price exceeds MC

The Monopolistic Competitor in the Short Run

The monopolistic competitor can make a profit or take a loss

As only one firm in a crowded industry it has a very elastic demand curve
No one firm can get too far out of line on price because buyers can always purchase a substitute from some one else
Monopoly

Monopolistic competitor

D MR
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

MR D

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Monopolistic Competitor Making a Profit in the Short Run

24 MC 22 20 18 16 14 D MR ATC

Price is $15

ATC is $12.10
Total Profit=(Price-ATC) X Output

12 10 8 6 4 2 0 0 10 20 30 40 50 60 70 Output 80 90 100 120

=($15-$12.10) X 60 =($2.90) X 60 = $174

140

160

Output is 60
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Monopolistic Competitor Taking a Loss in the Short Run

24 MC 22 20 18 16 14 ATC

ATC is $12.80 Price is $11

Total Profit=(Price-ATC) X Output

12 10 8 6 4 2 0 0 10 20 30 40 50 60 70 Output 80 90 100 120 140 160 MR

=($11-$12.80) X 42 =(-$1.80) X 42 = -$75.60

Output is 42
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Monopolistic Competitor Breaking Even in the Long Run

24 MC 22 20 18 ATC

At the output level associated with MC=MR, the ATC curve is tangent to the demand curve

16 14 12 10 8 6 4 2 MR 0 0 10 20 30 40 50 60 70 Output 80 90 100 120 140 160

Output is 40
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Price Discrimination
Question Does price discrimination raise or lower profit? Price discrimination selling the same good or service at a number of different prices. Basically an illegal activity under the Clayton Act unless there is a cost justification for the price discrimination Answer Price discrimination is a marketing means to increase economic profit

Price Discrimination

Methods of price discrimination -- Discriminate among groups of buyers works when different buying groups are willing to pay different prices (on the average) for the same good or service Example: Airline travel prices target business travelers vs leisure time travelers -- discriminator is advance notice, shorter the notice, the higher the price

Some Examples of Price Discrimination

Doctors often charge rich patients more than poor patients

They may have one price for those with insurance and another price for those without insurance

Movies in the evening cost more than those in the early afternoon Senior citizen, youth, and student discounts New and used cars Youth fairs on airlines Evening meals in restaurants often cost more than the same meal at lunch

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Practicing Price Discrimination

The firm that practices price discrimination must be able to distinguish between two or more separate groups of buyers Price discriminators must also be able to prevent buyers from reselling the product or service

For example, if a fifteen-year-old could resell his youth fare seat to an adult who could then use it, the price discrimination effort would fail

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Motives for Price Discrimination

In most cases, price discrimination is basically a mechanism for rationing goods and services The main motivation for price discrimination is to raise profits

The greater the price discrimination, the greater the profits because buyers lose some of their consumer surplus If price discrimination were carried to its logical conclusion, we would have perfect price discrimination

The buyers would lose all of their consumer surplus

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Price Discrimination

Methods of discrimination -- Discriminate among units firm charges the same price to all customers but there are volume discounts

The key idea is to figure a way to charge those

incremental buyers who are willing to pay more a higher price

Result Consumer Surplus is converted to Producer

Surplus

Price Discrimination

Perfect Price discrimination occurs when a firm figures out how to extract the entire consumer surplus (page 357) Once the firm has the entire consumer surplus, the MR curve becomes the Demand Curve At that point, the firm extracts even more economic profit by increasing production to the point where MR(D) = MC (page 357)

Price Discrimination

Efficiency When the firm increases output to the point where MC = D, the efficient quantity is produced, but The producer has taken all the consumer surplus, and Since there is ample economic profit, the firm may be induced to spend money (increase costs) to protect its economic profit (rent seeking and is usually political in nature)

Is the Monopolistic Competitor Inefficient?

From a purely economic standpoint . . .Yes!

The firms do not produce at the minimum point on the ATC There may be too many firms in most industries

Are there too many beauty parlors? Not if you want to get your hair done on Friday afternoon or Saturday morning Are there too many restaurants? Not on Sunday Would Americans want the drab businesses that characterize eastern Europe and the old soviet union? Would Americans want only one brand of toothpaste or one brand and model of a car?

There may be overdifferentiation

In America, it would be hard to imagine a no-frills world

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Closing Thoughts

More than 99% of the over 23 million business firms in the United States are monopolistic competitors While price competition exists, they compete more vigorously over differentiation characteristics such as ambience, service, convenience, quality, brand awareness, etc.