Monopolistic competition (0)

Monopolistic Competition
Market Power
Firms in monopolistic competition or imperfectly competitive markets are more likely to have limited market power because there are many firms with differentiated products (there are substitutes ) and there is relative ease of entry and exit into the market
Market Power among Sellers

• Monopolistic competition - a market with a large number of sellers and relatively free entry; each firm “differentiates” its product.
  
• Oligopoly - a market characterized by significant barriers to entry and “a few “sellers who recognize their interdependence in the market; products may be homogeneous or differentiated.
  

Monopolistic Competition

• Large number of sellers
  
• relative ease of exit / entry
  
• products are differentiated
  
  • actual differentiation
    
  • perceived differentiation
    

Only difference from pure comp. is that the demand faced by the firm is not perfectly elastic; MR will lie below the Demand function (AR)
Relaxing the characteristic of outputs from homogeneous to “differentiated products” was the basic change from the purely competitive market model.
Thedifferentiation of output results in the demand faced by each seller being less than perfectly elastic.

• Since there are “many sellers,” many substitutes for each seller’s output is implied.
  

This suggests that the demand faced by a firm in a monopolistically competitive market is likely more elastic than in a monopoly .
The elasticity obviously depends on the preferences and behavior of the buyers.
The negative slope of a firm’s demand function in imperfect competition results in a different result than in pure competition
The conditions of entry and exit to and from a monopolistically competitive market are similar to the purely competitive market; there are no major BTE.

• Entry and exit are relatively easy. The relative ease of entry/exit makes the long run results of an imperfectly competitive market different from a monopoly.
  

Price Discrimination

• Question – Does price discrimination raise or lower profit ?
  

Price discrimination – selling the same good or service at a number of different prices.

• Answer – Price discrimination is a marketing means to increase economic profit
  

Methods of price discrimination

• Discriminate among groups of buyers
  

• works when different buying groups are willing
  
• to pay different prices (on the average ) for the same good or service
  

Example: Airline travel – prices target business travelers vs. leisure time travelers

• discriminator is advance notice , shorter the notice, the higher the price
  

Some Examples of Price Discriminations

• Doctors often charge rich patients more than poor patients
  
  • They may have one price for those with insurance and another price for those without insurance
    
• Movies in the evening cost more than those in the early afternoon
  
• Senior citizen, youth , and student discounts
  
• New and used cars
  
• Youth fairs on airlines
  
• Evening meals in restaurants often cost more than the same meal at lunch
  

Practicing Price Discrimination
The firm that practices price discrimination must be able to distinguish between two or more separate groups of buyers
Price discriminators must also be able to prevent buyers from reselling the product or service

• For example, if a fifteen- year -old could resell his youth fare seat to an adult who could then use it, the price discrimination effort would fail
  

Motives for Price Discrimination

• In most cases, price discrimination is basically a mechanism for rationing goods and services
  

The main motivation for price discrimination is to raise profits

• The greater the price discrimination, the greater the profits because buyers lose some of their “ consumer surplus ”
  
• If price discrimination were carried to its logical conclusion, we would have perfect price discrimination
  
  • The buyers would lose all of their “consumer surplus”
    

Price Discrimination
Methods of discrimination

• Discriminate among units – firm charges the same price to all customers but there are volume discounts
  

The key idea is to figure a way to charge those incremental buyers who are willing to pay more a higher price

• Result – Consumer Surplus is converted to Producer Surplus
  
• Efficiency – When the firm increases output to the point where MC = D, the efficient quantity is produced, but
  

The producer has taken the entire consumer surplus, and since there is ample economic profit, the firm may be induced to spend money (increase costs ) to protect its economic profit (rent seeking and is usually political in nature )
Monopolistic Competition and the Welfare of Society
There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.
However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.
Another way in which monopolistic competition may be socially inefficient:

• The number of firms in the market may not be the “ ideal ” one.
  

• There may be too much or too little entry.
  

The product-variety externality:

• Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.
  

The business-stealing externality:

• Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.
  

Advertising
When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product.

• Critics of advertising argue that firms advertise in order to manipulate people’s tastes.
  

They also argue that it impedes competition by implying that products are more different than they truly are.

• Defenders argue that advertising provides information to consumers
  

They also argue that advertising increases competition by offering a greater variety of products and prices.

• The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.
  

Brand

• Critics argue that brand names cause consumers to perceive differences that do not really exist.
  
• Economists have argued that brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality.
  
  • Providing information about quality.
    
  • giving firms incentive to maintain high quality
    

Examples of Monopolistic Competition

• Banks
  
• Sporting Goods
  
• Radio Stations
  
• Fish and Seafood
  
• Clothing
  
• Jewelry
  
• Computers
  
• Health Spas
  
• Frozen Foods
  
• Apparel Stores
  
• Canned Goods
  
• Convenience Stores
  

Summary
A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry.
The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.

• Monopolistic competition does not have all of the desirable properties of perfect competition.
  

There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost.

• The number of firms can be too large or too small.
  

The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names.

• Critics argue that firms use advertising and brand names to take advantage of consumer irrationality and to reduce competition.
  
• Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.
  

Oligopoly
Characteristics:

• A “few sellers” who recognize their interdependence
  
• Products may be homogeneous or differentiated
  
• Significant barriers to entry exist
  

Explanations of oligopoly behavior require knowledge of competitors’ behavior
Kinked Demand Model

• An oligopolist whose price and output choice is dependent on competitors’ behavior.
  
• Firms tend to have capacity to increase output
  
• Consumers see goods as substitutes
  
• Two service stations at an off- ramp
  

Dominant Firm Model
In some markets there is a single firm that controls a dominant share of the market and a group of smaller firms.
The dominant firm sets prices which are simply taken by the smaller firms in determining their profit maximizing levels of production .
This type of market is practically a monopoly and an attached perfectly competitive market in which price is set by the dominant firm rather than the market.

• The demand curve for the dominant firm is determined by subtracting the supply curves of all the small firms from the industry demand curve.
  

After estimating its net demand curve (market demand less the supply curve of the small firms) the dominant firm maximizes profits by following the normal p-max rule of producing where marginal revenue equals marginal costs.
The small firms maximize profits by acting as PC firms - equating price to marginal costs.
Cournot -Nash Model

• The Cournot-Nash model is the simplest oligopoly model.
  

The models assumes that there are two “equally positioned firms”; the firms compete on the basis of quantity rather than price and each firms makes an “output decision assuming that the other firm’s behavior is fixed.”

• The market demand curve is assumed to be linear and marginal costs are constant .
  

To find the Cournot-Nash equilibrium one determines how each firm reacts to a change in the output of the other firm.
The path to equilibrium is a series of actions and reactions.
The pattern continues until a point is reached where neither firm desires “to change what it is doing , given how it believes the other firm will react to any change.

• The equilibrium is the intersection of the two firm’s reaction functions .
  

The reaction function shows how one firm reacts to the quantity choice of the other firm.
Bertrand Model

• The Bertrand model is essentially the Cournot-Nash model except the strategic variable is price rather than quantity.
  

The model assumptions are:

• There are two firms in the market
  
• They produce a homogeneous product
  
• They produce at a constant marginal cost
  
• Firms choose prices PA and PB simultaneously
  
• Firms outputs are perfect substitutes
  
• Sales are split evenly if PA = PB
  

• The only Nash equilibrium is PA = PB = MC.
  

Neither firm has any reason to change strategy . if the firm raises prices it will lose all its customers. If the firm lowers price P unit sold.

• The Bertrand equilibrium is the same as the competitive result.
  
• Each firm will produce where P = marginal costs and there will be zero profits