Monopolistic Competition PDF

Monopolistic Competition Dr. Sanja Samirana Pattnayak Monopolistic Competition ⚫ Numerous buyers and sellers ⚫ Differentiated products Implication: Since products are differentiated, each firm faces a downward sloping demand curve. ⚫ Consumers view differentiated products a...

Monopolistic Competition Dr. Sanja Samirana Pattnayak Monopolistic Competition ⚫ Numerous buyers and sellers ⚫ Differentiated products Implication: Since products are differentiated, each firm faces a downward sloping demand curve. ⚫ Consumers view differentiated products as close substitutes: there exists some willingness to substitute. ⚫ Free entry and exit 2 ⚫ Differentiation is a source of market power.  This makes a firm face downward sloping demand curve for its own variety.  Products are differentiated but highly substitutable: I prefer KFC whereas you prefer McDonald’s if only if price difference is not significant.  The greater the differentiation the higher the potential for earning profits.  Firms may enjoy excess profits in the short run but earning only normal profit in the long run. 3 ⚫ The amount of monopoly power depends on the degree of differentiation. ⚫ Therefore, firms in monopolistically competitive industries attempt to convince consumers that their products are better than those offered by other firms. 4 ⚫ The usual strategies to persuade consumers are:  Comparative advertising to create so called “Brand Equity”  Niche Marketing: Keep introducing not only “new, improved products (more efficient laundry detergent) but completely different product lines. (Example below) ⚫ Green marketing: want to lure certain segment of the market that is concerned with environmental issues (A toy has a package label indicating recycled plastic was used. 5 Managing a Monopolistically Competitive Firm ⚫ Like a monopoly, monopolistically competitive firms  have market power that permits pricing above marginal cost. ⚫ But …  The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist.  Free entry and exit impacts profitability. ⚫ Therefore, monopolistically competitive firms have limited market power. 6 Short-Run Monopolistic Competition ⚫ 7 8 Long Run Adjustments ⚫ If the industry is truly monopolistically competitive, there is free entry. In this case other “greedy capitalists” enter, and their new brands steal market share. This reduces the demand for your product 9 Effect of Entry on a Monopolistically Competitive Firm’s Demand 10 Long-Run Equilibrium under Monopolistic Competition 11 Long Run Adjustments? ⚫ 12 Optimal Advertising Decisions ⚫ Advertising is one way for firms with market power to differentiate their products. ⚫ But, how much should a firm spend on advertising?  Advertise to the point where the additional revenue generated from advertising equals the additional cost of advertising.  Equivalently, the profit-maximizing level of advertising occurs where the advertising-to-sales ratio equals the ratio of the advertising elasticity of demand to the own-price elasticity of demand. A EQ , A = R − EQ , P 13 ⚫ Two aspects of the formula worth noting. The more elastic the demand for a firm’s product the lower the optimal advertising to sales ratio. In perfect competition, the optimal advertising to sales ratio is zero. why? Firms having market power will generally find it optimal to engage in some degree of advertising. But exactly how much such firms should spend on advertising, however, depends on the quantitative impact of advertising on demand. 14 Example ⚫ The more sensitive demand is to advertising i.e., the greater the advertising elasticity, the greater the number of additional units sold because of a given increase in advertising expenditures, and thus the greater the optimal advertising to sales ratio. 15 Example ⚫ Let’s assume that a firm in a monopolistically competitive industry seeks to bolster profits. The price elasticity of demand Ep was estimated to be -10. The advertising elasticity of demand was estimated to be 0.2. To maximize profits, what fraction of revenue should the firm spend on advertising? ⚫ Ep = -10, Advertising elasticity is 0.2 ⚫ Find the advertising to sales ratio which is equal to 0.2/10=0.02 ⚫ So optimal advertising to sales ratio is 2 percent – to maximize profits, the firm should spend 2 percent of its revenue on advertising. 16 Maximizing Profits: A Synthesizing Example ⚫ C(Q) = 125 + 4Q2 ⚫ Determine the profit-maximizing output and price, and discuss its implications, if You are a price taker and other firms charge $40 per unit; You are a monopolist and the inverse demand for your product is P = 100 - Q; You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q. 17 Marginal Cost ⚫ C(Q) = 125 + 4Q2, ⚫ So MC = 8Q. ⚫ This is independent of market structure. 18 Price Taker ⚫ MR = P = $40. ⚫ Set MR = MC. ⚫ 40 = 8Q. ⚫ Q = 5 units. ⚫ Cost of producing 5 units. ⚫ C(Q) = 125 + 4Q2 = 125 + 100 = $225. ⚫ Revenues: ⚫ PQ = (40)(5) = $200. ⚫ Maximum profits of -$25. ⚫ Implications: Expect exit in the long-run. 19 Monopoly/Monopolistic Competition ⚫ MR = 100 - 2Q (since P = 100 - Q). ⚫ Set MR = MC, or 100 - 2Q = 8Q. Optimal output: Q = 10. Optimal price: P = 100 - (10) = $90. Maximal profits: ⚫ PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375. ⚫ Implications Monopolist will not face entry (unless patent or other entry barriers are eliminated). Monopolistically competitive firm should expect other firms to clone, so profits will decline over time. 20 Conclusion ⚫ Firms operating in a perfectly competitive market take the market price as given. Produce output where P = MC. Firms may earn profits or losses in the short run. … but, in the long run, entry or exit forces profits to zero. ⚫ A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated. ⚫ A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time. 21