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Lecture 9: Monopolistic Competition Characteristics of Monopolistic Competition: 1. 2. 3. 4.

Many buyers and many sellers The Producers sell a similar product differentiated by brand names Free Entry and Exit Perfect Information

Monopolistic competition is similar to perfect competition in that there are many buyers and many sellers, free entry and exit, and perfect information. Therefore, we also expect there to be zero economic profits in monopolistically competitive industries in the long run. However, monopolistically competitive firms are different than perfectly competitive ones in that they sell a differentiated product. So, we expect to see a downward sloping demand curve. An example of monopolistic competition is the industry for cigarettes, where there are many sellers of a slightly differentiated brand (Marlboro, Winston, Camel, Salem, etc). Let the following figure represent the demand for La Siestas Mexican food. Suppose that La Siesta is one of three Mexican restaurants in Murfreesboro. Let the others be Rio Bravo and Cozomels. The graph shows La Siestas brand of Mexican food and the corresponding demand for that brand of food.
Price MC ATC

MR

D (La Siesta) Quantity

La Siesta maximizes profits by selecting q* where MC=MR. Find q* on the graph. La Siesta finds the optimal price to charge, p*, by identifying the price on the demand curve for q* units of output. Economic profits are the difference between the price (p*) and the average cost of producing q* units of output. Explain why MC=MR is the profit maximizing rule for q*. Show that if a quantity is picked that is less than q*, then the opportunity to earn economic profits is being passed

up because there are units for which MR>MC, yet they arent produced. If a quantity is picked that is greater than q*, then some units are being produced for which MC>MR. With positive economic profits, we will see entry. In the long run, there will be entry, which will shift the demand curve and the marginal revenue curve to the left for La Siesta. This happens because (i) some people no longer want La Siestas food; they want the Mexican food offered by the new restaurants and (ii) some people want both La Siestas Mexican food and the food offered by the new entrant for variety. Now that the demand curve has shifted inward some, re-maximize profits and determine whether there are still positive economic profits. If there are, then there will be further entry. Now show where we reach a long run equilibrium when there is no more pressure for changes such as entry of new firms. Re-maximize profits. Find q*, p*, and calculate economic profits. Show that this is a long run equilibrium with zero economic profits.
MC Price ATC

MR

D Quantity

Compare Monopolistic competition in the short run and long run: Figures A and B show the cost structure for a firm in a monopolistically competitive market.
Figure A Price Price MC $100 ATC $80 $60 $40 $30 MR 4 7 D 10 Quantity 5 $65 $40 MR D 9 Quantity Figure B MC

Compare the monopolistically competitive firms in the short run with monopolistically competitive firms in the long run. Is there more variety in the short run or in the long run? Compare the monopolistically competitive firms in the short run with monopolistically competitive firms in the long run. Are firms more efficient in the short run or in the long run?

Compare Monopolistic Competition with Perfect Competition: Figure A shows the cost structure for La Siesta, which is a Mexican restaurant in a monopolistically competitive industry, and the demand for La Siesta brand Mexican food. Figure B depicts the cost structure of an Orange farmer in Florida, who is operating in a perfectly competitive market where the market-clearing price for oranges is 50 cents.
Figure A Price Price MC ATC $8.00 $0.50 $4.00 $2.50 MR 4 7 D 9 Quantity 10 Quantity ATC Figure B MC

Define efficiency. Does La Siesta, which is operating in a monopolistically competitive industry, operate efficiently? Does the Orange farmer in the perfectly competitive industry operate efficiently? Define excess capacity. What is La Siestas excess capacity? What is the orange farmers excess capacity?

Advertising is a natural behavior in monopolistic competition. It is used to increase demand for its particular product. Do you think that advertising makes markets more or less competitive? Critique of Advertising: Manipulates peoples tastes Psychological rather than informational Creates a desire that might not otherwise exist Impedes competition by convincing consumers that products are more different that they truly are, fostering brand loyalty (increasing a firms market power). This makes the demand curve more inelastic allowing the firm to charge a larger markup over marginal cost. Defense of Advertising: Provides information about the goods being offered, existence of new products, and locations of firms. Fosters competition by making customers more aware of all the firms in the industry. Makes customers more aware of price differences, allowing them to exploit these price differences. This pressures the firms to charge similar prices. Also allows new firms to attract customers. Case study: Some states allowed advertising by optometrists for eyeglasses and some states did not. In the states that prohibited advertising, the average price of glasses was $33, while states that allowed advertising had average eyeglasses prices of $26 (20% lower). Now suppose that you are a producer of jeans in a monopolistically competitive industry. This industry is monopolistically competitive because there are other producers of jeans, though each firms product is slightly differentiated. For example, your jeans are acid-washed with four pockets while a competitors jeans might not be acid-washed with six pockets. Further, each producer has her own brand name. The chart below describes the demand for your product at various prices. Assume the marginal cost of producing each unit of output (the material) is $5.00 and fixed costs (the factory) are $10.00.

Quantity Demanded (initial) 0 1 2 3 4 5 6 7 8 9 10

Marginal Revenue (initial)

Quantity Demanded (new)

Marginal Revenue (new)

Total Revenue (initial)

Total Revenue (new)

$20.00 $18.00 $16.00 $14.00 $12.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00

How many pairs of jeans should you produce to maximize profits? What price should you charge? Calculate economic profits. Now consider advertising. How would advertising affect your cost structure? Would advertising be a fixed or variable cost? How would advertising affect the demand for your product? Incorporate the changes to the cost of production and the demand for your product just described. Then, find the new profit maximizing quantity, price, and profit levels.

Price

$0 $18.00 $32.00 $42.00 $48.00 $50.00 $48.00 $42.00 $32.00 $18.00 $0

$18.00 $14.00 $10.00 $6.00 $2.00 -$2.00 -$6.00 -$10.00 -$14.00 -$18.00

Problem Set 9: Monopolistic Competition 1. The market for coffee at coffeehouses in Chapel Hill can be called monopolistically competitive since there are only a few sellers of a slightly differentiated product. This leaves each coffee shop with some market power. Below is shown Carolina CoffeeHouses cost curves and the demand curve CCH faces in the short run when positive economic profits are being made. a) Find and label the profit-maximizing price and quantity for CCH in Figure 1 with a p* and Q*. b) Shade in economic profits. c) Explain whether you expect these economic profits to persist in the long run and explain why.
Figure 1 Price MC ATC

MR

D Quantity

2. Below is shown what Carolina CoffeeHouse's (CCHs) cost curves look like in the long run. a) Describe the adjustment process that must have occurred for this monopolistically competitive firm to reach long run equilibrium if in the short run the firm was making positive economic profits. In your description, be sure to explain which curves have shifted and which curves have not when compared to Figure 1 above where positive economic profits are being made in the short run. b) Monopolistically competitive markets are often called inefficient. Why? c) In what way is society better off when firms in a monopolistically competitive market are in the short run making positive economic profits when compared to monopolistically competitive markets in the long run? Does society gain anything when monopolistically competitive markets move from short run equilibrium to long run equilibrium?

Figure 2 MC Price ATC

MR

D Quantity

3. The Mexican restaurant industry in Columbia, TN, is monopolistically competitive, and El Rodeo is a Mexican restaurant in this market. The figure below represents El Rodeo's short-run cost structure and the demand for El Rodeos food. a) b) c) d) e) f) g) h) What is the profit maximizing quantity for El Rodeo to produce? What is El Rodeos profit maximizing price? Calculate El Rodeo's short run profits. Given the characteristics of monopolistically competitive industries, how will El Rodeo's economic profits change in the long run? Assume that El Rodeo is operating on the most efficient scale of production in the short run, as are the other firms in the industry. Will there be more firms in the Mexican food industry in the long run? How would El Rodeos profits have changed in the long run if barriers prevented entry of new firms? What characteristics do monopolistically competitive and perfectly competitive firms share? What characteristics do monopolistically competitive firms and monopolies have in common?
Monopolistic Competition

50 48 46 44 42 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Quantity Demand Marginal Revenue Marginal Cost Average Total Cost

4. You are a producer of bottled water in a monopolistically competitive industry. This industry is monopolistically competitive because there are other producers of bottled water, though each firms product is slightly differentiated. For example, you get your water for bottling from a stream in the Allegheny Mountains of West Virginia while competitors get their water from streams elsewhere. Further, each producer has her own brand name. The chart below describes the demand for your product at various prices. Assume the marginal cost of producing each unit of output (transportation from the Allegheny Mountains to the market) is $0.30 and that there are no fixed costs of production. Quantity Demanded (initial) 0 1 2 3 4 5 6 7 8 9 10 Marginal Revenue (initial) Quantity Demanded (new)

Marginal Revenue (new)

Total Revenue (initial)

Total Revenue (new)

$2.00 $1.80 $1.60 $1.40 $1.20 $1.00 $0.80 $0.60 $0.40 $0.20 $0.00 a) b) c)

How much bottled water should you produce to maximize profits? What price should you charge? Calculate economic profits.

Since economic profits are positive, new firms are attracted to the industry. In particular, a new firm that gets water from the Colorado Rocky Mountains enters the industry and demand for your bottled water correspondingly decreases by 2 at each price. d) According to economic theory, when new firms enter an industry, what should happen to prices? e) Find your new profit maximizing quantity, price, and profit levels.

Price

0 0 0 1 2 3 4 5 6 7 8

10

Answer Key 9: Monopolistic Competition Answer to question 1. a) The profit-maximizing price is p* and the profit-maximizing quantity is Q*. b) Economic profits are positive and are between p* and ATC* for all Q* units. This is a rectangle with height p*-ATC* and length Q* for (p*-ATC*)Q*. c) The economic profits will not persist in the long run since there is free entry in monopolistic competition. The demand curve for CCH will shift inward as more firms enter the coffeehouse industry. The demand curve for CCH coffee will continue to shift inward until there are no longer any positive economic profits. Figure 1
Price MC p* ATC* ATC

MR Q*

D Quantity

Answer to question 2. a) Free entry in monopolistically competitive markets has resulted in new firms entering to get some of the positive economic profits. This entry shifts CCHs demand curve inward. Consequently, the marginal revenue curve has shifted inward as well. These two curves continue to shift until there are zero economic profits. The MC and ATC curves do not shift. b) Monopolistically competitive markets are often called inefficient because they do not drive costs to their minimum point on the average cost curve in the long run as in perfectly competitive markets. This is because there is product differentiation in monopolistically competitive markets. c) In the short run, the monopolistically competitive firm is closer to the lowest point on its ATC curve than in the long run. This aspect makes the short run look better than the long run. But, the change that occurs in the long run is new firms enter, which shifts the demand curve for any particular brand to the left. Though this puts production on a higher point on the average cost curve, the fact that new firms have entered means there are more brands on the market. For example, a larger selection of a slightly differentiated product means more kinds of toothpaste, more coffee houses, more kinds of cigarettes, etc. So, efficiency is sacrificed as we move from the short run to the long run for the sake of a wider selection of brands of a particular product; efficiency is sacrificed for variety.

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Figure 2 MC Price ATC

MR

D Quantity

Answer to question 3. a) q* = 13 because thats where MC=MR. b) p* = $37.00 c) (p-ATC)*Q equals (37-16)13 = $273.00. d) They will go to zero economic profits in the long run because there is entry in monopolistically competitive markets. New firms will be attracted to this industry until there are no longer positive economic profits to be made. e) The positive economic profits in the short run will attract the entry of new firms, resulting in more firms in the long run. f) The positive economic profits would have existed in the long run if there is no entry of firms. g) Perfect competition and monopolistic competition are similar in that they both have entry of new firms and zero economic profits in the long run. Also, both markets are assumed to have perfect information and many buyers and sellers. h) Monopoly and monopolistic competition are similar in that they both have downward sloping demand curves and perfect information. Answer to question 4: a) Produce 4 units of output. b) Charge a price of $1.20 per bottle. c) Profits are $1.20*4 - $0.30*4 = $3.60. d) The new profit maximizing quantity is 3 units of output at a price of $1.00. Profits are $1.00*3 - $0.30*3 = $2.10.

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Quantity Demanded (initial) 0 1 2 3 4 5 6 7 8 9 10

Marginal Revenue (initial)

Quantity Demanded (new)

Marginal Revenue (new)

Total Revenue (initial)

Total Revenue (new)

$2.00 $1.80 $1.60 $1.40 $1.20 $1.00 $0.80 $0.60 $0.40 $0.20 $0.00

Price

$0.00 $1.80 $3.20 $4.20 $4.80 $5.00 $4.80 $4.20 $3.20 $1.80 $0.00

$1.80 $1.40 $1.00 $0.60 $0.20 -$0.20 -$0.60 -$1.00 -$1.40 -$1.80

0 0 0 1 2 3 4 5 6 7 8

$0.00 $0.00 $0.00 $1.40 $2.40 $3.00 $3.20 $3.00 $2.40 $1.40 $0.00

0.00 0.00 1.40 1.00 0.60 0.20 -0.20 -0.60 -1.00 -1.40

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