lecture 10: monopolistic competitio · lecture 10 agsm©2004 page 2 1. between two poles number of...

LECTURE 10: MONOPOLISTIC COMPETITIOToday’s Topics: Brands and Adver tising1. Between Monopoly and Perfect Competition:

number of sellers? type of products?oligopolies, monopolistic competition.

2. Monopolistic Competition: competition inthe short run, in the long run; compared withperfect competition, and efficiency.

3. Adver tising: pros and cons, as a signal ofquality, brand names.

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Lecture 10 A G S M © 2004

1. BETWEEN TWO POLESNumber of Sellers:

One A Few ManyHomog enous Homog eneous PureProduct Pure Oligopoly CompetitionDifferentiated Monopoly Differentiated MonopolisticProduct Oligopoly Competition

Assume: Many Buyers

“I think it’s wrong only one company makes the game Monopoly”— US humorist, Steve Wright

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Lecture 10 A G S M © 2004 Page 2



Assume: Many Buyers


Oligopoly: a market structure in which only a fewsellers offer similar or identical products. Oftenbehave strategically. (Lecture 17.) Examples?

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Assume: Many Buyers


Oligopoly: a market structure in which only a fewsellers offer similar or identical products. Oftenbehave strategically. (Lecture 17.) Examples?

Monopolistic Competition: a market structure inwhich many firms sell products that are similar butnot identical.

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DIFFERENTIATED PRODUCTS

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HOMOGENEOUSor

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HOMOGENEOUSor

DIFFERENTIATED?

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HOMOGENEOUSor

DIFFERENTIATED?

Degree of Substitutability?Attributes:

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HOMOGENEOUSor

DIFFERENTIATED?


• Physical Attributes

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HOMOGENEOUSor

DIFFERENTIATED?


• Physical Attributes• Ancillar y Ser vices

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HOMOGENEOUSor

DIFFERENTIATED?


• Physical Attributes• Ancillar y Ser vices• Geographical Location

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HOMOGENEOUSor

DIFFERENTIATED?


• Physical Attributes• Ancillar y Ser vices• Geographical Location• Subjective Image

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2. MONOPOLISTIC COMPETITIONFor a firm with market power in a market with withother firms selling close substitutes,

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2. MONOPOLISTIC COMPETITIONFor a firm with market power in a market with withother firms selling close substitutes, there iscompetition as firms enter,

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2. MONOPOLISTIC COMPETITIONFor a firm with market power in a market with withother firms selling close substitutes, there iscompetition as firms enter, and chang e the pricesof the close substitutes,

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2. MONOPOLISTIC COMPETITIONFor a firm with market power in a market with withother firms selling close substitutes, there iscompetition as firms enter, and chang e the pricesof the close substitutes, which results in a shift tothe left in the demand curve that our firm faces.

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→ Monopolistic Competition

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→ Monopolistic Competition

Examples?

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CONDITIONS FOR MONOP. COMP.

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1. Many sellers competing by sellingdifferentiated (such as branded) products.

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2. Because the products are differentiated(substitutes, but not perfect substitutes),each firm faces a downwards-slopingdemand curve and has some market powerto determine price.

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3. Free entry or exit from the market: until zeroeconomic profits for all.

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4. Firms do not collude or behave strategically:they assume competitors’ actions fixed.

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4. Firms do not collude or behave strategically:they assume competitors’ actions fixed.

5. Buyers are price takers; no bargaining.

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IN THE SHORT RUN

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IN THE SHORT RUN

1. Prices of substitutes affect the demandcur ve , downwards-sloping. (imperfectsubstitutes)

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IN THE SHORT RUN


2. Assume that each firm takes others’ actionsconstant & then sets sales (yy *

SR ) so thatMRMR(yy *

SR) = MCMC(yy *SR) (SRSR = Shor t Run)

to maximize its profit ( yy *SR → PP *

SR ).

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IN THE SHORT RUN






SR ).

3. In general, PP *SR > AC (AC (yy *) for each firm, so

that profit ππ is positive in the short run.

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IN THE SHORT RUN






SR ).

3. In general, PP *SR > AC (AC (yy *) for each firm, so

that profit ππ is positive in the short run.∴ attractive for new firms to produce close

substitutes in the long run.< >


POSITIVE PROFITS

$/unit

output/period

..................................................................................................................................................................................................................

...................................

...........................

........ACAC

.........................................................................................................................................................................................................................................

................................................................................................................................................................................................................................................................................................................................................................................ MCMC

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POSITIVE PROFITS

$/unit

output/period

..................................................................................................................................................................................................................

...................................

...........................

........ACAC

.........................................................................................................................................................................................................................................

................................................................................................................................................................................................................................................................................................................................................................................ MCMC

...................................................................................................................................................................................................................

DD

DD = ARAR

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POSITIVE PROFITS

$/unit

output/period

..................................................................................................................................................................................................................

...................................

...........................

........ACAC

.........................................................................................................................................................................................................................................

................................................................................................................................................................................................................................................................................................................................................................................ MCMC

...................................................................................................................................................................................................................

DD

DD = ARAR

PPSR

yySR

................................................... MRMR

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POSITIVE PROFITS

$/unit

output/period

..................................................................................................................................................................................................................

...................................

...........................

........ACAC

.........................................................................................................................................................................................................................................

................................................................................................................................................................................................................................................................................................................................................................................ MCMC

...................................................................................................................................................................................................................

DD

DD = ARAR

PPSR

yySR

................................................... MRMR

.......................................................

DD′

DD′ = ARAR′

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POSITIVE PROFITS

$/unit

output/period

..................................................................................................................................................................................................................

...................................

...........................

........ACAC

.........................................................................................................................................................................................................................................

................................................................................................................................................................................................................................................................................................................................................................................ MCMC

...................................................................................................................................................................................................................

DD

DD = ARAR

PPSR

yySR

................................................... MRMR

.......................................................

DD′

DD′ = ARAR′

PP′

yy′

................................................... MRMR′

With demand DD , profit attracts new entrants, whichcontracts the demand to DD ′.

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POSITIVE PROFITS

$/unit

output/period

..................................................................................................................................................................................................................

...................................

...........................

........ACAC

.........................................................................................................................................................................................................................................

................................................................................................................................................................................................................................................................................................................................................................................ MCMC

...................................................................................................................................................................................................................

DD

DD = ARAR

PPSR

yySR

................................................... MRMR

.......................................................

DD′

DD′ = ARAR′

PP′

yy′

................................................... MRMR′

With demand DD , profit attracts new entrants, whichcontracts the demand to DD ′.Profit falls, but still positive: ARAR ′(yy ′) = PP ′ > ACAC(yy ′).

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LONG-RUN EQUILIBRIUM

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4. In the medium-to-long run, new entrantsinvest, and the original firms’ demand curvesmove to the left, as their market share falls.

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5. In the long run ( LRLR ), all profits will be biddedaway for the marginal firm, with

ARAR = DD ≡ PP = ACAC ∴ ππ = 0and maximum (zero) profit point on demandcur ve

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5. In the long run ( LRLR ), all profits will be biddedaway for the marginal firm, with

ARAR = DD ≡ PP = ACAC ∴ ππ = 0and maximum (zero) profit point on demandcur ve

∴ the demand curve DD ′′ must be tangent to theACAC cur ve at the price & output chosen.

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC...................................................................................................................................................................................................................

DD

D =D =ARAR

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC...................................................................................................................................................................................................................

DD

D =D =ARAR

.............................................

DD′′

DD′′ = ARAR′′

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC...................................................................................................................................................................................................................

DD

D =D =ARAR

.............................................

DD′′

DD′′ = ARAR′′PP′′

yy′′

........... MRMR′′

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC...................................................................................................................................................................................................................

DD

D =D =ARAR

.............................................

DD′′


yy′′

........... MRMR′′

Long-run equilibrium at the margin.

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC...................................................................................................................................................................................................................

DD

D =D =ARAR

.............................................

DD′′


yy′′

........... MRMR′′


At yy ′′ , ARAR ′′(yy ′′) = PP ′′ = ACAC(yy ′′): zero profit.

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC...................................................................................................................................................................................................................

DD

D =D =ARAR

.............................................

DD′′


yy′′

........... MRMR′′



There will be excess capacity: firms will notoperate at minimum ACAC , and so they could reduceAC by increasing output.

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ZERO PROFITS

$/unit

output/period

.....................................................................................................................................................................................

...............................................................................

ACAC

...................................................................................................................................................................................................................................................

......................................................................................................................................................................................................................................................................................................................................................................MCMC...................................................................................................................................................................................................................

DD

D =D =ARAR

.............................................

DD′′


yy′′

........... MRMR′′



There will be excess capacity: firms will notoperate at minimum ACAC , and so they could reduceAC by increasing output. Why don’t they?

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VERSUS PERFECT COMPETITION

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VERSUS PERFECT COMPETITIONHigher average costs: zero profits, but firms are onthe downwards-sloping part of the ATCATC cur ves, notat the minimum (Efficient Scale).

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Mark-up over marginal cost: price is always aboveMCMC , because the firm always has some marketpower, not PP = MCMC .

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Note that MCMC < ACAC , since ACAC is falling, not MCMC =ACAC .

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Note that MCMC < ACAC , since ACAC is falling, not MCMC =ACAC .

Always eager to make another sale: an extra unitsold at the current price means more profit, notunwilling.

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AND EFFICIENCYInefficient, but greater variety in the market.

Inefficiencies:

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Inefficiencies:

1. Mark-up: PP > MCMC ∴ the DWL of monopolypricing: some consumers value it above MCMCbut below the PP charged.

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Inefficiencies:


2. Production yy ′′ less than the Efficient Scale ofproduction at minimum ACAC : excesscapacity.

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Inefficiencies:



3. Too much or too little entry: individualentrant considers only its profit,

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Inefficiencies:



3. Too much or too little entry: individualentrant considers only its profit, butconsumers gain CSCS with a new product,

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Inefficiencies:



3. Too much or too little entry: individualentrant considers only its profit, butconsumers gain CSCS with a new product,while incumbents lose PSPS with the newcompetitor.

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3. ADVERTISINGA natural feature of monopolistic competition:each firm wants more sales.

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Print media: 50%Electronic media: 33%Rest: 17%

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How does the level of adver tising vary over typesof goods and services?

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Highest adver tising budg ets for highlydifferentiated consumer goods.

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Highest adver tising budg ets for highlydifferentiated consumer goods.

Examples?

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PRO & CON

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PRO & CONManipulation of tastes? Creating desires thatotherwise wouldn’t exist?

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Higher prices (for two reasons)?

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Higher prices (for two reasons)? Because PP > MCMC ,and

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Higher prices (for two reasons)? Because PP > MCMC ,and by reducing consumers’ price elasticity ofdemand (brand loyalty).

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OR

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ORConveys information (prices, locations, existenceof new products) → better choices?

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ORConveys information (prices, locations, existenceof new products) → better choices? Morecompetition, not less (think: Internet comparisonbrowsing).

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ORConveys information (prices, locations, existenceof new products) → better choices? Morecompetition, not less (think: Internet comparisonbrowsing). Reduces brands’ market power.

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ORConveys information (prices, locations, existenceof new products) → better choices? Morecompetition, not less (think: Internet comparisonbrowsing). Reduces brands’ market power.Facilitates entry.

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Empirical results:

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Empirical results: Across 50 states: price ofspectacles 20% lower when adver tising allowed.

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AS A SIGNAL OF QUALITY

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AS A SIGNAL OF QUALITYHow much information?

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The firm’s willingness to buy adver tising(especially for repeat-purchase , experience goods)is a signal of quality?

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Is what the adver t says important?

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Is what the adver t says important? Not much —just that it is expensive and paid for.

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BRAND NAMESEconomics of brand names:

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Perceived differences, not real — a rip-off, fromadver tising.

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But:Quality — firms use brands to convey signalsabout quality; and, firms must defend their brands’reputations (or brand equity) as high-qualityproducts by maintaining quality.

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Rationality: irrational preference for brand names,or

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Rationality: irrational preference for brand names,or for good reason?

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SUMMARY1. Between monopoly and perfect competition

lie most markets: oligopolies (few sellers) ormonopolistic competition (many sellers).

2. Monopolistic Competition: Neither perfectcompetition, nor pure monopoly: manysellers and zero profit, but a price mark-up.

3. Many products → variety for consumers!4. Adver tising to increase sales. Justified or

not?

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APPENDIXUnder what conditions is it true that the slope ofthe MRMR cur ve ( dMRdMR

dQdQ ) is twice that of the ARAR (i.edemand) curve ( dPdP

dQdQ )?

RR = QQ •P (Q)P (Q)∴ MRMR = dRdR

dQdQ = P (Q)P (Q) + QQ dPdPdQdQ = PP •(11 + 11

ηη ).

The slope of the MRMR cur ve is given by:dMRdMRdQdQ = 22 dPdP

dQdQ + QQ dd 2PPdQdQ2

So it is only true in general for linear demandcur ves, for which dd 2PP

dQdQ2 = dddQdQ ( dPdP

dQdQ ) = 0,0, because theirslopes are constant (but not, of course , theirelasticities).

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lecture 10: monopolistic competitio · lecture 10 agsm©2004 page 2 1. between two poles number of...

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