Chapter 17: Monopolistic Competition – Key Vocabulary

Introduction: Observing Monopolistic Competition in Everyday Life

• Bookstore example
  • Wide variety of titles (James Patterson, Maya Angelou, Ron Chernow, Stephenie Meyer) ⇒ many sellers for similar-but-unique products.
  • Prices greatly exceed marginal cost of printing.
  • Entry is easy (anyone can self-publish), profits are typically low.
  • Illustrates a market that is neither perfectly competitive nor pure monopoly, but monopolistically competitive.

Positioning Monopolistic Competition on the Market-Structure Spectrum

• Polar cases already studied
  • Perfect competition (Chapter 15): P = MC, zero economic profit in LR.
  • Monopoly (Chapter 16): P > MC, positive LR profit, DWL.
• Imperfect competition = any structure between the two extremes.
• Two main types of imperfect competition:
  • Oligopoly: a few sellers, strategic interaction important; measured by four-firm concentration ratio.
  • Monopolistic competition: many sellers, differentiated products, free entry/exit.
• Four-firm concentration ratio
  • Indicator of oligopoly power.
  • Industries ≥ 90\% (aircraft, tobacco, rental cars, express delivery) are classic oligopolies.

Core Attributes of Monopolistic Competition

1. Many sellers: Each firm is small relative to the overall market.
2. Product differentiation: Goods are close but not perfect substitutes ⇒ downward-sloping individual demand curves.
3. Free entry & exit: Firms can freely join or leave ⇒ LR economic profit driven to 0.

• Examples: books, video games, restaurants, piano lessons, cookies, clothing, etc.
• Decision tree for classifying markets
  • Q1: Number of firms? 1 ⇒ monopoly; few ⇒ oligopoly; many ⇒ go to Q2.
  • Q2: Products identical? Yes ⇒ perfect competition; No ⇒ monopolistic competition.

Firm Behavior with Differentiated Products

Short-Run Decision (MR = MC)

• Demand curve slopes downward ⇒ firm behaves like a small monopoly.
• Profit maximization rule: choose Q where MR = MC; charge price P from demand curve.
• Two possible SR outcomes (Figure 2):
  • Profit: P > ATC ⇒ shaded profit rectangle.
  • Loss minimization: P < ATC but continue operating if P > AVC.

Long-Run Dynamics (Entry & Exit)

• Positive profit ⇒ new entrants shift each incumbent’s demand left (less demand at every P) until profits = 0.
• Losses ⇒ exits shift remaining firms’ demand right until profits = 0.
• LR equilibrium conditions (Figure 3):
  • Demand curve is tangent to ATC curve (touches but does not cross).
    P = ATC and economic profit = 0.
  • Still have monopoly-like markup: P > MC because MR < P.

Comparing Monopolistic & Perfect Competition (Figure 4)

1. Excess capacity
   • Perfect competition: firms produce at efficient scale (minimized ATC).
   • Monopolistic competition: produce on downward-sloping portion of ATC ⇒ output below efficient scale.
2. Markup over marginal cost
   • Perfect competition: P = MC.
   • Monopolistic competition: P > MC due to market power.
   • Even with zero economic profit, markup persists because MC < ATC at the tangency point.
3. Implications for customer acquisition
   • Competitive firm indifferent to 1 extra buyer (additional 9\ profit).
   • Monopolistic competitor values extra customers: additional unit sold at P > MC raises profit.

Welfare Analysis & Externalities of Entry

• Deadweight loss from markup: some consumers with MB > MC don’t buy.
• Difficulties of regulation
  • Enforcing P = MC would create losses (since P = ATC already), requiring subsidies.
  • Scope: would have to regulate vast numbers of differentiated-product firms.
• Externalities of entry
  1. Product-variety externality (positive): new varieties raise consumer surplus.
  2. Business-stealing externality (negative): incumbents lose customers/profits.
• Net welfare effect ambiguous ⇒ market may have too many or too few firms; policy fixes are hard.

Advertising (Section 17-3)

• Natural outgrowth of differentiated products + markup.
• Spending patterns:
  • Consumer packaged goods: 10\text{–}20\% of revenue.
  • Industrial goods: minimal.
  • Homogeneous commodities: almost none.
  • Aggregate economy: ≈ 2\% of total revenue.

The Debate

Critique

• Manipulates tastes via psychological appeals (e.g., soft-drink beach party).
• Increases perceived differentiation ⇒ demand becomes less elastic ⇒ higher markup.

Defense

• Provides useful info on prices, new products, purchase methods.
• Lowers search costs ⇒ makes demand more elastic ⇒ lower markups.
• Facilitates entry for new firms (e.g., professional services once banned from ads).

Empirical Evidence (Natural Experiments)

1. Optometrist ads (Benham, 1972)
   • States banning ads: avg eyeglasses price =\$33 (\$288 2021 dollars).
   • States allowing ads: =\$26 (\$227 2021 dollars).
   • ⇒ Ads cut prices > 20\%.
2. Liquor price ads (Milyo & Waldfogel, 1999)
   • After Rhode Island ban overturned: stores that advertised cut prices > 20\% on advertised items and gained share.

Advertising as a Costly Signal of Quality

• Model: Kellogg vs General Mills launching new cereal at \$5/box, marginal cost 0.
  • Advertising campaign cost: \$20\text{ million}.
  • Kellogg (good cereal): repeat sales = 12 \times 1\text{M boxes} \times \$5 = \$60\text{M} ⇒ advert profitable.
  • General Mills (bad cereal): one-time sales = \$5\text{M} ⇒ advert unprofitable.
• Consumers rationally interpret high ad spending as signal of quality.
• Cheap ads fail as signals; must be costly & thus credible.

Brand Names

• Observations: brand sellers charge higher prices and advertise heavily (e.g., Bayer vs generic aspirin; Coke/Pepsi vs store cola).

Critics

• Brand loyalty based on illusions; differences minimal ⇒ resource waste.
• Chamberlin: suggested refusing to enforce trademarks.

Defenders

1. Information role: conveys quality when pre-purchase inspection is hard.
2. Incentive role: preserves firm’s reputation; high future profits at stake ⇒ maintain quality.

• Example: choosing McDonald’s in unfamiliar town; reputational loss from food-borne illness is nationwide.

Quick Quiz Recap (with correct concepts)

1. Monopolistically competitive firm is NOT a price taker (b is false).
2. Best MC example among options: haircuts.
3. Firm increases production if MR > MC.
4. New entry occurs when P > ATC (positive profit).
5. LR equilibrium: P > MC, P = ATC, \text{economic profit}=0.
6. Ads that increase loyalty ⇒ decrease elasticity, increase markup (c).
7. Ads that improve awareness ⇒ increase elasticity, decrease markup (b).
8. Advertising signals quality when benefit of attracting customers is larger for high-quality firms (b).

Mathematical & Statistical Highlights

• Hardcover novel list price ≈ \$30; marginal printing cost < \$10.
• E-book price ≈ \$15; marginal download cost \approx 0.
• Four-firm concentration ratio: common threshold <50\% for most U.S. industries; ≥ 90\% ⇒ oligopoly.
• Advertising share of revenue: economy-wide ≈ 2\%; consumer packaged goods 10\text{–}20\%.

Connections to Earlier & Future Chapters

• Relates to Chapter 15 (perfect competition) and Chapter 16 (monopoly): combines properties of both.
• Sets stage for Chapter 18 (oligopoly) where strategic interaction is key.
• Reinforces concepts of MR, MC, ATC, LR zero profit, DWL, and externalities.

Practical, Ethical, and Policy Implications

• Excess capacity might seem wasteful but is voluntary trade-off for variety.
• Markup-induced DWL exists but regulating price to MC would require subsidies and heavy oversight.
• Advertising restrictions can unintentionally harm consumers by raising prices.
• Trademarks & brand names serve both competitive (info) and anticompetitive (loyalty) roles; blanket suppression may reduce quality incentives.

Chapter-in-a-Nutshell (Condensed)

• Monopolistic competition: many firms + differentiated products + free entry.
• LR equilibrium: excess capacity, P>MC, P=ATC, zero profit.
• Welfare: DWL + ambiguous entry externalities; tough for policy to improve.
• Differentiation ⇒ advertising & brand names; debate rages over manipulation vs information.