Chapter 15 (3) Flashcards
Remember that under the model of perfect competition –> firms do not make economic profits
►It’s not surprising, then, that firms would rather be operating under conditions of monopolistic competition
–> where they can make economic profits
How do monopolistic competitive firms make economic profits?
►By making a product that consumers perceive to be different from the products of their competitors
○ In other words,PRODUCT DIFFERENTIATION
PRODUCT DIFFERENTIATION
►firms must offer goods that are similar to competitors’ products –> but more attractive in some ways
► It is an essential part of the strategy of many businesses in the real world
Sometimes product differentiation = accomplished through genuine innovation
Regardless of whether or not genuine innovation = involved –> firms have an interest in persuading customers that their products are unique
○ This is the role of advertising & branding
► Even when a firm’s product = not really very different from other products on the market –> it may be possible to convince customers that the product is different
○ And thereby, persuade them to pay more for a particular brand
MONOPOLISTIC COMPETITION IN THE SHORT RUN
►Product differentiation enables firms in monopolistically competitive markets to produce a good for which there are no exact substitutes
○ In the short run –> this allows a firm to behave like a monopolist
○ In the long run –> the situation is different
When monopolistically competitive firms can behave like monopolistic competition (Figure 15-2) shows these short-run production choices:
- Firms face a downward-sloping demand curve
a. Just like a monopolistic –> a monopolistically competitive firm cannot adjust its price w/out causing a change in the quantity consumers demand - Assuming that production involves both fixed & marginal costs
a. Firms face a U-shaped average total cost (ATC) curve - The profit-maximizing production quantity is at the point where the marginal revenue (MR) curve intersects the marginal cost (MC) curve
a. The profit-maximizing price = determined by the point on the demand curve that correspond to this quantity
In summary, a monopolistically competitive firm can earn positive economic profits in the short run
To do so, it must behave just like a monopolist–by producing at the point where MR = MC
MONOPOLISTIC COMPETITION IN THE LONG RUN
► For all of their similarities in the short run –> the monopolistically competitive firm faces one huge problem that the monopolist does not: firms can enter the market
○ When existing firms are making economic profits –> other firms have an incentive to enter the market
Ø It’s not always possible for other firms to enter the market & produce EXACTLY the same product
○ Example: there’s only one Elvis - and he belongs to Sun Records
○ What other firms can do is look for artists who are LIKE Elvis–and whose records will therefore be seen by music lovers as a closer substitute for Elvis records
What effect does the entry of more firms have on the demand faced by each existing firm?
►Remember from Chapter 3 that availability of substitute goods = one of the determinants of demand
○ More firms making more products that are similar to the original product means that consumers have a wider range of substitutes
○ With more product options from which consumers can choose –> demand for the original product decreases at every price
►The demand curve faced by the firm shifts to the left
As long as firms currently in the market are earning economic profits –> more firms will enter the market w/ products that are close substitutes
○ As a result, the demand curve will continue to shift to the left
○ This process will continue until potential firms no longer have an incentive to enter the market
►When does this happen? - at the point when existing firms are no longer earning economic profits
The opposite logic holds if firms in the market are losing money in the short run
►Firms will have an incentive to exit the market when they are earning negative profits
○ These exits drive up demand for the existing firms & shift the demand curves they face to the right
►This process will continue, until, in the long run –> firms are breaking even and no longer have an incentive to exit
In the long run:
► Firms in a monopolistically competitive market face the same situation as firms in a perfectly competitive market:
○ Profits are driven to zero
►Remember from earlier chapters that zero profit means that total revenue is exactly equal to total cost
► In per-unit terms, zero profit means that price is equal to average total cost (ATC)
► (Figure 15-3) shows this situation; the ATC curve is tangent to the demand curve exactly where ATC = price
○ That point represents the profit-maximizing quantity & is the optimal production point
Note that ATC touches the demand curve at the same quantity where MR intersects MC
○ This graphic relationship is equivalent to saying that profits are zero
►If ATC is not exactly tangent to the demand curve at the optimal point –> then profits are positive/negative
►If ATC = above the demand curve - for example, this would mean that costs were higher than price –> and firms would lose money & exit the market
If, on the other hand, ATC hit the demand curve at multiple places –> costs would be below price & firms would earn profits
○ This situation would induce firms to enter the market
○ This process of entry & exit –> which moves the demand curve left/right –> continues until this relationship does hold
In the long run: monopolistic competition has some features in common w/ monopoly & others in common w/ perfect competition
Just like monopoly, a monopolistic competitive firm faces a downward-sloping demand curve
○ Such a curve means that MR = less than price
○ This in turn means that MC = also less than price
► But, like a firm in a perfectly competitive market –> a monopolistically competitive firm earns zero economic profits in the long run
These differences have (2) important implications:
- Monopolistically competitive firms operate at smaller-than-efficient scale
- Monopolistically competitive firms want to sell more
- Monopolistically competitive firms operate at smaller-than-efficient scale
► The optimal production point for a monopolisitcally competitive firm in the long run will be where the ATC curve touches the demand curve
► Because the demand curve = downward-sloping –> this will always be on the decreasing section of the ATC curve
This contrasts w/ the situation in a perfectly competitive market –> in which firms’ optimal production is at the lowest point on the ATC curve
When firms produce the quantity that minimizes ATC (as in a perfectly competitive market) –> we say they are operating at their efficient scale
In contrast, monopolistically competitive firm maximizes profits by operating at a smaller scale than the efficient one
Aka meaning that the firm has excess capacity
- Monopolistically competitive firms want to sell more
►Perfectly competitive market: price is equal to MC
○ If the firm sold an additional unit at that price –> MC would rise above price & profit would fall
Monopolistically competitive firm: sells at a price that is equal to ATC –> but higher than MC
○ If the firm was able to sell an additional unit w/out lowering the price –> that unit would generate more revenue than coast & so increase the firm’s profit
► In other words, as soon as we depart from the model of perfect competition –> firms have an incentive to engage in tactics for bringing in more customers–such as advertising & brand promotion
