11/28/2009

CHAPTER
16 The Big Picture

Chapter 13: The cost of production

Monopolistic Competition
Now, we will look at firm’s revenue

But revenue depends on market structure
PRINCIPLES OF 1. Competitive market (this chapter)
Economics 2. Monopoly (chapter 15)
N. Gregory Mankiw
3. Monopolistic Composition (chapter 16)
4. Oligopoly (chapter 17)
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CHAPTER
14 CHAPTER SUMMARY

For a firm in a perfectly competitive market,

Firms in Competitive Markets price = marginal revenue = average revenue.

If P > AVC, a firm maximizes profit by producing
PRINCIPLES OF the quantity where MR = MC. If P < AVC, a firm
Economics will shut down in the short run.
N. Gregory Mankiw
If P < ATC, a firm will exit in the long run.

In the short run, entry is not possible, and an
increase in demand increases firms’ profits.
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Perfect Competition CHAPTER

15

Products are Perfect Substitutes

Result: Price Taking
Monopoly

P = MR = MC
PRINCIPLES OF

SR: Will operate if P > AVC (FC is sunk) Economics

LR: Will operate at P = ATC N. Gregory Mankiw

Firms enter if P > ATC; exit if P < ATC

Homework: Mankiw, Ch.14, pp. 308-310, Premium PowerPoint Slides
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CHAPTER SUMMARY CHAPTER SUMMARY

A monopoly firm is the sole seller in its market.
Monopoly firms maximize profits by producing the
Monopolies arise due to barriers to entry, including: quantity where marginal revenue equals marginal
government-granted monopolies, the control of a cost. But since marginal revenue is less than
key resource, or economies of scale over the entire price, the monopoly price will be greater than
range of output. marginal cost, leading to a deadweight loss.

A monopoly firm faces a downward-sloping
Monopoly firms (and others with market power)
demand curve for its product. As a result, it must try to raise their profits by charging higher prices
reduce price to sell a larger quantity, which causes to consumers with higher willingness to pay.
marginal revenue to fall below price. This practice is called price discrimination.

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CHAPTER SUMMARY Monopoly

MR=MC to maximize profit (still true!)

Policymakers may respond by regulating
But, P > MR (D - downward sloping)
monopolies, using antitrust laws to promote
Welfare Cost of a Monopoly:
competition, or by taking over the monopoly and
Profits (unfair??) vs. DWL (efficiency loss!!)
running it. Due to problems with each of these
options, the best option may be to take no action.

Cures? Do nothing? Auction off the market

Or, just auction off the market. (Demsetz, 1968)
Homework: Mankiw, Ch. 15, pp. 340-343,

Problem 1, 3, 7, 9, 11, 12, 13

CHAPTER
16 In this chapter,
look for the answers to these questions:

Monopolistic Competition
What market structures lie between perfect

competition and monopoly, and what are their
characteristics?
PRINCIPLES OF

Economics
How do monopolistically competitive firms choose

price and quantity? Do they earn economic profit?
N. Gregory Mankiw

In what ways does monopolistic competition affect
society’s welfare?
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Introduction: Characteristics & Examples

Between Monopoly and Competition of Monopolistic Competition
Characteristics:
Two extremes

Many sellers

Perfect competition (perfect substitutes): many
firms, identical products

Product differentiation:
 Location, location, location! (產品定位)

Monopoly (no close substitute): one firm

Free entry and exit
In between these extremes: imperfect competition Examples:

Oligopoly: only a few sellers offer similar or
apartments
identical products.
books

Monopolistic competition: many firms sell
bottled water
similar but not identical products.
clothing
= Partial Substitutes!
fast food
MONOPOLISTIC COMPETITION 12 MONOPOLISTIC COMPETITION 13

Comparing Perfect & Monop. Competition Comparing Monopoly & Monop. Competition
Perfect Monopolistic Monopolistic
Monopoly
competition competition competition
number of sellers one many
number of sellers many many
free entry/exit no yes
free entry/exit yes yes

long-run econ. profits zero zero long-run econ. profits positive zero

the products firms sell identical differentiated firm has market power? yes yes

firm has market power? none, price-taker yes downward-

downward-
D curve facing firm sloping
downward- sloping
D curve facing firm horizontal (market demand)
sloping
close substitutes none many
MONOPOLISTIC COMPETITION 14 MONOPOLISTIC COMPETITION 15

A Monopolistically Competitive Firm A Monopolistically Competitive Firm

Earning Profits in the Short Run With Losses in the Short Run
The firm faces a For this firm,
downward-sloping P < ATC
D curve. Price Price
MC at the output where MC
profit
At each Q, MR < P. MR = MC.
P ATC losses ATC
To maximize profit, The best this firm
ATC ATC
firm produces Q can do is to
D P
where MR = MC. minimize its losses.

MR D
The firm uses the
D curve to set P. MR
Q Quantity Q Quantity

MONOPOLISTIC COMPETITION 16 MONOPOLISTIC COMPETITION 17

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Monopolistic Competition and Monopoly A Monopolistic Competitor in the Long Run

Short run: Under monopolistic competition,
Entry and exit
firm behavior is very similar to monopoly.
occurs until

Long run: In monopolistic competition, P = ATC and Price
entry and exit drive economic profit to zero. profit = zero. MC

If profits in the short run: Notice that the ATC
New firms enter market, firm charges a P = ATC
taking some demand away from existing firms, markup of price markup
prices and profits fall. over marginal cost
D

If losses in the short run: and does not MC
produce at MR
Some firms exit the market,
remaining firms enjoy higher demand and prices. minimum ATC. Q Quantity

MONOPOLISTIC COMPETITION 18 MONOPOLISTIC COMPETITION 19

Why Monopolistic Competition Is Monopolistic Competition and Welfare

Less Efficient than Perfect Competition

Monopolistically competitive markets do not
1. Excess capacity have all the desirable welfare properties of

The monopolistic competitor operates on the perfectly competitive markets.
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.

Because P > MC, the market quantity is below
the socially efficient quantity.

Under perfect competition, firms produce the
quantity that minimizes ATC.
Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
2. Markup over marginal cost to reduce prices.

Under monopolistic competition, P > MC.

Under perfect competition, P = MC.

MONOPOLISTIC COMPETITION 20 MONOPOLISTIC COMPETITION 21

Monopolistic Competition and Welfare ACTIVE LEARNING 1

Number of firms in the market may not be optimal, Advertising
due to external effects from the entry of new firms: 1. So far, we have studied three market

The product-variety externality: structures: perfect competition, monopoly, and
surplus consumers get from the introduction monopolistic competition. In each of these,
of new products would you expect to see firms spending money

The business-stealing externality: to advertise their products? Why or why not?
losses incurred by existing firms
when new firms enter market 2. Is advertising good or bad from society’s
viewpoint? Try to think of at least one “pro”

The inefficiencies of monopolistic competition are and “con.”
subtle and hard to measure. No easy way for
policymakers to improve the market outcome.

MONOPOLISTIC COMPETITION 22 23

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Advertising The Critique of Advertising

In monopolistically competitive industries,
Critics of advertising believe:
product differentiation and markup pricing
Society is wasting the resources it devotes to
lead naturally to the use of advertising. advertising.

In general, the more differentiated the products,
Firms advertise to manipulate people’s tastes.
the more advertising firms buy.
Advertising impedes competition –

Economists disagree about the social value of it creates the perception that products are
more differentiated than they really are,
advertising.
allowing higher markups.

MONOPOLISTIC COMPETITION 24 MONOPOLISTIC COMPETITION 25

The Defense of Advertising Advertising as a Signal of Quality

Defenders of advertising believe: A firm’s willingness to spend huge amounts

It provides useful information to buyers. on advertising may signal the quality of its product
to consumers, regardless of the content of ads.

Informed buyers can more easily find and
exploit price differences.
Ads may convince buyers to try a product once,

Thus, advertising promotes competition and but the product must be of high quality for people
reduces market power. to become repeat buyers.

The most expensive ads are not worthwhile

Results of a prominent study: unless they lead to repeat buyers.
Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers
When consumers see expensive ads,
they think the product must be good if the company
than in states that did not restrict such advertising.
is willing to spend so much on advertising.

MONOPOLISTIC COMPETITION 26 MONOPOLISTIC COMPETITION 27

Brand Names The Critique of Brand Names

In many markets, brand name products coexist
Critics of brand names believe:
with generic ones.
Brand names cause consumers to perceive

Firms with brand names usually spend more on differences that do not really exist.
advertising, charge higher prices for the products.
Consumers’ willingness to pay more for brand
names is irrational, fostered by advertising.

As with advertising, there is disagreement about
Eliminating govt protection of trademarks
the economics of brand names… would reduce influence of brand names,
result in lower prices.

MONOPOLISTIC COMPETITION 28 MONOPOLISTIC COMPETITION 29

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The Defense of Brand Names CONCLUSION

Defenders of brand names believe:
Differentiated products are everywhere;

Brand names provide information about quality examples of monopolistic competition abound.
to consumers.
The theory of monopolistic competition describes

Companies with brand names have incentive many markets in the economy,
to maintain quality, to protect the reputation of
yet offers little guidance to policymakers looking
their brand names.
to improve the market’s allocation of resources.

MONOPOLISTIC COMPETITION 30 MONOPOLISTIC COMPETITION 31

CHAPTER SUMMARY CHAPTER SUMMARY

A monopolistically competitive market has
Monopolistic competition does not have all of the
many firms, differentiated products, and free entry. desirable welfare properties of perfect competition.

Each firm in a monopolistically competitive market There is a deadweight loss caused by the markup
has excess capacity – produces less than the of price over marginal cost. Also, the number of
quantity that minimizes ATC. Each firm charges a firms (and thus varieties) can be too large or too
price above marginal cost. small. There is no clear way for policymakers to
improve the market outcome.

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CHAPTER SUMMARY Monopolistic Competition

Most close to reality

Product differentiation and markup pricing lead to

Differentiated Products:
the use of advertising and brand names. Critics of
Location, location, location!
advertising and brand names argue that firms use
SR: Like a monopoly (locally)
them to reduce competition and take advantage of
consumer irrationality. Defenders argue that firms

LR: Zero profits
use them to inform consumers and to compete
Homework: Mankiw, Ch.16, pp. 363-364,
more vigorously on price and product quality. Problem 1, 2, 4, 10, 11

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