microeconomics product differentiation, monopolistic

This is Microeconomics

Product Differentiation, Monopolistic Competition, and Oligopol~

As is typical in many firms, there seems to be a hybrid between competitive firms and monopolies. In this chapter, we will study a model that is widely used by economists to explain the behavior of such firms. It is called monopolistic competition. Monopolistic competition occurs in an industry with many firms and free entry and where the product of each firm is slightly differentiated from the product of every other firm to make the product more attractive. Examples are resta11rants, hotels , car dealerships, furniture stores , and clothin g stores.

The 4 Market Structures Perfect/Pure Competition 1. profit max. and Q: P=MC and MR MC 2. P is constant 3. no DWL or excess costs/capacity 4. one product/many close substitutes 5. many producers 6. no barriers to entry/exit 7. no market power/price taker 8. perfectly elastic D curve 9. no LR profit 10. example: stock market

Oli2opoly (imperfect competition) 1. profit max. determined by strategic heh. 2. P decreases, P>MC, & MR<P 3. DWL and excess costs/capacity 4. standardized/differentiated products 5. a few big producers 6. barriers to entry/exit 7. market power/price maker 8. sloping D curve 9. LR profit 10. example: sneaker market

Monopolistic Competition (imperfect) 1. profit max. and Q: MC=MR 2. P decreases, P>MC, & MR<P 3. DWL & excess costs/capacity 4. differentiated products 5. many producers 6. no barriers to entry/exit 7. market power/price maker 8. sloping D curve 9. no LR profit 10. example: cereal market

Monopoly (imperfect competition) 1. profit max. and Q: MC=MR 2. P decreases, P>MC, & MR<P 3. DWL and excess costs/capacity 4. one product/no close substitutes 5. one big producer 6. barriers to entry/exit 7. market power/price maker 8. sloping D curve 9. LR profit with economies of scales 10. example: US Steel/FPL (nat. mono.)

Product Differentiation The effort by firms to create products (all types of goods) that are different from other firms' products in ways that people value is called product differentiation. Because consumers often have 11niqi1e preferences, prod11ct differentiation aims to tap that market and benefit financially from it. Goods for which there are no product differentiations, such as gold bullion (99.5% pure gold), are called homogeneous products, meaning that the products are all the same. Aspirin is not an example of prad11ct differentiation; it was a brand new product when it was invented in 1 897. The coatin 2 that makes it easier to swallow the aspirin is an example of product differentiation, as is Pepsi to the original invention of Coke in 1886. For every firm, there is an optimal level of proch1ctjon djfferentjatjon that brings about the balance between total revenue (TR) and total (TC) costs.

Monopolistic Competition Monopolistic competition gets its name from the fact that it is a hybrid of monopolies and competitive markets . Recall that monopolies have a downward-slo ping market curve and barriers to entry . Compet itive markets have many sellers , each having a horizontal demand curve with no barriers to entry or exit. Monopolistic competition has ma,ny fions with free entry and exit , but each firm has a downward-slo pin~ demand curve for its product because of its product differentiation; its unique products set it aside enou gh to warrant its own demand (D) curve and be a price-maker, not a price-taker. In addition, monopolistic competitive industries set their price (E) and quantit y (Q) between those of a competitive market and a

A Firm in a Perfectly Competitive / Pure Market

monopoly. Afjrm So.cia Hy opl imal . S~ ~~,,-e alto cll t h 't"ly a111td ~,·~

product i , ·t·I.Y l'fTI,·it.·nt . P ric e a n d profit maxi m izing (S) 1"' S uppl y

Equlllbriu:i Qua n tity quv.ntit) ' (Qe)

Monopolistic Competition (cont.) When a monopolistically competitive firm raises (t) its price (P), the quantity demanded (Qd) of its product goes down (.!.) but does not plummet to zero, as is the case in a competitive firm in an industry with numerous close product substitutes. If Nike raises its prices, it will lose some sales to Reebok, but not a lot because there will always be those who prefer Nike to Reebok. Nike's customers have a low price elasticity of demand (PED) (the sensitivity and impact on demand when prices change). The two companies have differentiated products to one another. On the other hand, wheat is wheat, so in this homogeneous situation, one firm raising its prices can lose it a substantial chunk of the market share, like with perfectly elastic demand (huge changes in demand due to slight changes in price). If one paperclip company raises its prices, they might lose a huge portion of their demand (D).

Monopolistic Competition-Questions 11. Tl1 d rnand ur f r a 111 n p Ii ti ally

111p titi, 1 fir111 i d \Vn\vard I ping b au

A th r arc a larg nu111b r f fi1n1 (B tl1 r lu ti I r du d by u ing ar

(D E)

r ur tl1 pr dt1 t pr dt1

ar n t id nti al it i a y f r fi1111 t tl1 111aroinal t ri

d by diff r nt fir111

nt r r it tl1 111ark t a utput {)f du d

Monopolistic Competition-Questions 11. Tl1 d rnand ur f r a 111 n p Ii ti ally

111p titi, 1 fir111 i d \Vn\vard I ping b au

A th r arc a larg nu111b r f fi1n1 ._ nope , not too many or them

(B tl1 r lu ti Ir du d by u ing ar , r ur

• tl1 pr dt1 t pr dt1 ar n t id nti al

(D it i a y f r fi1111 t E) tl1 111aroinal t ri

resources are always scarce

d by diff r nt fir111 nope, there are barriers to entry

nt r r it tl1 111ark t ~ a utput pr du d-......._

has nothing to do with the question

A Typical Monopolistic Competitor Monopolies and monopolistic competitors both have downward -sloping demand (D) curves . However, the information we get from a demand curve is dj fferent for a monopolistic compet itor becaus ,e there are other firms in the industry. The demand curve is llill the market demand curve , as is with a monopoly. It is the demand curve that is specific to each firm, like an individual demand curve. For example, when L.A. Gear entered the market against Nike and Reebok~ each of the farmer two shifted their demand curve to the left because of the decrease (Jr) in demand. When firms left, the demand curve shifted to the right.

Monopolistic Competition (cont.) Observe that the demand (D) curve has been drawn so that it just touches the average total cost (ATC) curve. At that point, the profit-maximizin g price equals the average total cost in the long-run (LR), just like in a competitive firm, and price is greater than ma;rgioa.J cost (MC) . Total revenue (TR) is equal to total costs (TC), and profits are zero. This is the breakeven point , equilibrium. Notice also the marginal revenue (MR) curve and how it slopes downward below zero.

Monopolistic Competition Breakeven ©

ATC

price

Mono:01. Quantity Comp. quantity

Monopolistic Competition (cont.) There is either a positive profit or negative profit (loss) because price (EJ is either greater than or less than the average total cost (ATC).

Monopolistic Competition Profit ©

Price

Monopol. Comp. -+ -

P price

Monopol. Comp. quantity

Quantity

Monopo istic Competition Losses ®

Price

Mono:01. Quantity

Comp. quanti~ ·

Monopolistic Competition-Questions 10. Which f th foll wing i trt1 i r both a

m n p li ti ally c 1npetitiv firm ancl a p rf tly c rnpetitive fir1n in l ng-run equilibrium'.

(A) Marginal t i gr at r than 1narginal r v nu .

(B Pric i great r than 1narginal co t. (C Pri i qual t a rag t tal t. (D) Pric i qual to rnarginal c t. (E Marginal r v nu i qual t av rag

r v nu .

Monopolistic Competition-Questions 10. Which f th foll wing i trt1 i r both a

m n p li ti ally c 1npetitiv firm ancl a p rf tly c rnpetitive fir1n in l ng-run equilibrium'.

(A) Marginal t i gr at r than 1narginal• nope, ror both in 1ong-run f V nu . equilibrium MC = MC

(B Pric i great r than 1narginal co t.+- only in a monopoly

(• Pri i qual t a rag t tal t. (D) Pric i qual to rnarginal C t. +-only in a perfectly competitive market

(E Marginal r v nu i qual t av rag .._onlyincompetitivenrms

r v nu .

Microeconomics Do-Now o opol /.---_Satne

ono o · stic graph\ Co p tition

Pri

onopol~' /

0111p. TC • price

0 0 0 / .. onopol. Com quan i ,

The Short-Run: Just T,ike a Monopoly In the short run ~ ), for both mono polies and mono polistic competitors, profit maximization is the same: set the quantit y produced where marginal revenue (MR) eg_uals marginal cost (MC). Because the monopolistic competitor has a downwardsloping demand curve, it balances the firm's profit-maximizing price and increases revenue from a higher price (P) with the lost customers who won't pay the higher price. The marginalrevenue-equals-marginal-cost condition achieves the balance. Lenscrafters and Pearle Vision are not monopolies, but the downward-slope of their demand curves makes their decision making similar to monopolies; they each have market power, In this sense, each firms' decision in setting quantity produced and price (P) is the same in mono polies and monopolistic competitors.

The 1 ,ong-Run Monopolistically Competitive Equilibrium There are two differences between monopolistically competitive firms and competitive firms in the long-run (LR). For monopolistically competitive firms, price m is greater than marginal cost ,MC) and mar~inal revenue (MR) is less than price. This was also true for the monopoly; it means that the market is not as efficient as a competitive market. The MR curve must be drawn to extend below $0, and where MR=O~ total revenue (TR) is at its max; no more revenue is attainable.

Monopolistic Competition

Price Profit ©

Monopol. Comp. quant ity

Qu anti ty

The 1 ,ong-Run Monopolistically Competitive Equilibrium (cont.) Production is lower because the price (E.) is higher than marginal cost (MC). Because each firm has some market power, it restricts output slightly and gets a higher price. The sum of the producer surplus (PS) and consumer surplus (CS) is reduced relative to that in a competitive market. In other words, there is a loss of efficiency, a deadweight loss (D WL).

Monopolistic Competition

Pric

1onopo_. omp. --. --

price P

Profit ©

lonopol. Comp. quantity

The 1 ,ong-Run Monopolistically Competitive Equilibrium (cont.) The quantity produced is nQ1 at the minimum point on the average total cost (ATC) curve, as it was for the competitive industry. That is, the quantity (Q) that the monopolistic competitor produces is at a higher cost point than the quantity the efficient competitor would p,roduce. Thus, monopolisticall y competitive firms operate in a situation of excess costs, when costs are higher than necessary.

Monopolistic Competition Profit ©

Price

onopol. Quantity

Comp. quantity

The 1 ,ong-Run Monopolistically Competitive Equilibrium (cont.) If each firm expanded production and lowered its price (J!_), average total cost (ATC) would decline. Each firm operates with some excess capacity, where actual production is less than what is achievable or optimal for a firm. The firms choose not to do so because they have some market power to keep their prices a little higher and the output a little lower than that.

The 1 ,ong-Run Monopolistically Competitive Equilibrium (cont.) A competitive market is efficient in that consumer (.GS.) and producer surplus (PS) are maximized and there is 1lD

deadweight loss (DWL). Average total cost (ATC) is minimiz ed and is equal to the price (J!)., creating a situation with no profit in the long-run (LR). In the short-run (2. ), a roauapaly and a company in monopolistic competition set their price (P) greater than the marginal cost (MC). In the long-run, a monopolisticall y competitive firms set their P = ATC, leading to no profit. A roauapaly is inefficient and its average total cost is not minimized, just like a monopolistically competitive firm, but economic profits remain positive for monopolies because firms cannot enter the market to compete.

The 1 ,ong-Run Monopolistically Competitive Equilibrium-Questions 59. Which of the following about the relation hip between marginal revenue (MR)

and price (P) under monopoli tic competition and perfect competition i correct ?

Monopoli tic Competition

(A) MR>P (B MR<P (C) MR decrease when P increases . (D) MR=P (E) MR=P

Perfect Competition

MR=P MR=P MR increa es when P decrease . MR=P MR<P

The 1 ,ong-Run Monopolistically Competitive Equilibrium-Questions 59. Which of the following about the relation hip between marginal revenue (MR)

and price (P) under monopoli tic competition and perfect competition i correct ?

Monopoli tic Competition Perfect Competition

(A) MR>P +-this can't be MR=P >

•I\ MR<P MR=P true J no way

(C) MR decrease when P incre~ es. ~ MR increa es when P decrease . ~ (D) MR=P > true, but this MR=P ..- true (E) MR=p nope MR P isn't true < ..-no way

The 1 ,ong-Run Monopolistically Competitive Equilibrium-Questions 37. Which of the following i true of a

monopoli tically competitive firm in long-run equilibrium?

A The firm produce the allocatively efficient level of output.

B The firm i allocatively inefficient .. becau e it produce an output level at which price i greater than marginal co t.

(C The firm produce an output level tha~ minimize average total co t.

D The firm produce in the inel tic range of it demand curve.

(E The firm earn po itive economic profi but zero accounting profi .

The 1 ,ong-Run Monopolistically Competitive Equilibrium-Questions 37. Which of the following i true of a


A The firm produce the allocatively efficient ... -- no way, only a compettive firm

level of output. • The firm i allocatively inefficient .. becau e it

produce an output level at which price i

can

greater than marginal CO t. nope, their ATC

( C The firm produce an output level tha ~ ..,.----is ~i~her than • • • .,..,.1 m1n1mal m1rum1ze average totai co t.

. . . . monopol ys and D The f 1rm produce 1n the 1nela tJc range of monopolistic

· t d d • nope, its between both ranges and conpet itive firms

LRATC

\ ~

1 eman curve. is unit elastic (neither)

(E The firm earn po itive economic profi but zero accounting profi . ......___ nope, profits=

0 in the LR

competitive firm in long-run equilibrium

The 1 ,ong-Run Monopolistically Competitive Equilibrium-Questions 10. Which of the following is true for both a

monopolistically competitive firm and a perfectly competitive firrn in long -run equ ilibrium ?

(A) Marginal cost is greater than 1narginal revenue.

(B) Price is greater than 1narginal co t. (C) Price is equal to average total co t. (D) Price is equal to marginal cost. (E) Marginal revenue is equal to average

revenue. 25. Which of the following is true of a


(A) Price exceed marginal revenue and the firm earns po itive economic profits .

(B) Price equals marginal revenue and the firm earns po itive economic profits.

(C) Price equals marginal co t, and the firm earns zero economic profits.

(D) Price exceed marginal cost and the firm earns zero economic profits .

(E) Price exceed marginal cost and the firm earns po itive economic profits.

The 1 ,ong-Run Monopolistically Competitive Equilibrium-Questions 10. Which of the following is true for both a

monopolistically competitive firm and a perfectly competitive firrn in long -run equ ilibrium ?

(A) Marginal cost is greater than tnarginal • nope; this is a loss revenue.

(B) Price is greater than 1narginal co t. .....- nope; this is a profit (. Price is equal to average total co t. +-remember ... neither can earn profit in the long-run (D) Price is equal to marginal cost. (E) ~ arginal revenue is equal to ~ e +-- marginal cost

recc .. ~ . 25. Which of the following is true of a


(A)

(B)

ce (D)

(E)

Price exceed marginal revenue and the firm earns po itive economic profits . ) nope, can't earn positive profits in the

Price equals marginal revenue and the firm long-run earns po itive economic profits.

Price equals marginal co t, and the firm earns zero economic profits.

Price exceed marginal cost and the firm earns zero economic profits . )remember ... it can't earn profit in the long-run

Price exceed marginal cost and the firm earns po itive economic profits.

Mononolistic Comnetition The graph below shows the demand curve (D), marginaJ revenue curve (MR), marginal cost curve (MC), average total cost curve (A TC). and long-run average totaJ cost curve (LRA TC) for a n1onopolist.

60

50

$40 -35 30

20--- ,-------------- MC= ATC= LRATC I I

IO --- :-----, --1 I I I .

() 2 4

I - ---- ,-----1 I

8 10

MR

I I I I I

' D 12 QUA:-ITITY

(a) Using the nun1bers given in the graph, ident ify each of the following for the profit-maximizing monopol ist.

(i) The quantity produced

(ii) The price

(iii) The alJocativeJy efficient quantity

(b) At the profit-maximizing quantity from part (a){i), is the monopolist experiencing economies of scaJe? Explain.

Mononolistic Comnetition The graph beJow shows the demand curve (D), marginal revenue curve (MR), marginal cost curve (MC), average totaJ cost curve (A TC), and long-run average total cost curve (LRA TC) for a monopolist .

~ u -~ ~

60

50

-----r-1 I

20 --- : -- - ---- - ------M C= ATC= LRATC I I

IO ---- :--------• I

() 2

. ------- ,-----1 I

8 10

MR

I I I I I

'D 12 QUANTITY

(c) Now assume that the monopolist produces 10 units. Using the numbers given in the graph, caJcuJate each of the following. Show your work.

(i) The monopolist's economic profit

(ii) The consumer surplus

(iii) The deadweight loss

(d) At what quantity is demand unit elastic?

(e) Suppose the monopolist perfectJy price <liscriminates and chooses the quantity that maximizes profit. Determine the dollar value of each of the foUowing.

(i) The monopolist's profit

(ii) The consumer surplus

Monopolistic Competition -(A -w S:? 0:: Q..

$60

$50

$40 $35 $30

$20

$ 10

0 2

(a) 3 points :

(d) 1 point : • One point is earned for identifying the quantity at which demand is unit elastic, 6.

(e) 2 points :

4 5

·• One point is earned for correctly determining the monopo list's profit . 1/2[($60 - $20) X 8J = $160

• One point is earned for correctly determining the consw11er surplus as zero.

8

MR

10

I I I I I

'D 12 QUANTrTY

• One point is earned for identifying the profit-maximizing quantity. Q = 4. • One point is earned for identifying the profit-maxjmi'Zing price , P = $40. • One point is earned for identifying the allocatively efficient outp ut , Q = 8.

(b) 1 point : • One point is earned for sta ting that the firm is not experiencing econom ies of sca le and for

exp laining that the LRATC is not downward sloping as outp ut increases or LRA TC remains constant as output increases .

(c) 3 points : • One point is earned for correctJy showing the calculation for the monopolist's economic

profit. 7'= (P - ATC) x Q = ($10 - $20) x 10 = - $100 Or loss of $100

Product Variety Versus Deadweigbt T ,oss When comparin g monopolistic competitive firms with competitive firms, we must recognize that replacing monopolistic competition with competition may be an impossibilit y or require a loss to society. Eliminatin g monopolistic competjtjon by having a sin2le product would probably reduce consumer surplus (CS) by more than the gain that would come from competition. Product differentiation may be of sufficient value to consumers that it makes sense to have monopolisticall y competitive firms despite the deadweight loss (D WL ). The deadwei ght loss from monopolistic competition is part of the price (P) consumers pay for the variety or the diversit y of products.

microeconomics product differentiation, monopolistic

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