Textbook Media Press. CH 12 Taylor: Principles of Economics 3e 1

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1 CH 12 Taylor: Principles of Economics 3e 1

2 Monopolistic Competition and Differentiated Products Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the product is sold, intangible aspects of the product, and perceptions of the product. CH 12 Taylor: Principles of Economics 3e 2

3 Perceived Demand for a Monopolistic Competitor The perceived demand curve for a monopolistically competitive firm is downward sloping Which shows that unlike a perfectly competitive firm with its flat perceived demand curve, a monopolistically competitive firm is not a price-taker, but rather chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is flatter than the perceived demand curve for a monopolist Because if a monopolistic competitor raises price, it will lose some customers to the competition, while a monopolist does not face any competition. CH 12 Taylor: Principles of Economics 3e 3

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5 How a Monopolistic Competitor Chooses Price and Quantity A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost. The monopolistic competitor will produce that level of output and charge the price based on its perceived demand curve. CH 12 Taylor: Principles of Economics 3e 5

6 EXHIBIT 12-2 How a Profit-Maximizing Monopolistic Competitor Decides What Price to Charge Step 1: The monopolistically competitive firm determines the profitmaximizing quantity of output by applying the rule MR = MC. In this case, the profit-maximizing output is 40. Step 2: The firm then decides how much to charge for this quantity by looking at its perceived demand curve. The vertical line up through a quantity of 40 hits the perceived demand curve at a price of $16. Step 3: The firm calculates total revenue, total cost, and profit. Total revenue is the rectangle with quantity on the horizontal axis and price on the vertical axis. Total cost is the rectangle with quantity on the horizontal axis and average cost on the vertical axis. Profit is total revenue of $640 minus total cost of $580, or $60, which is the more darkly shaded area in the diagram. CH 12 Taylor: Principles of Economics 3e 6

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8 Monopolistic Competitors and Entry If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering losses, then the industry will experience exit until profits are driven up to zero in the long run. CH 12 Taylor: Principles of Economics 3e 8

9 EXHIBIT 12-3 Monopolistic Competition, Entry, and Exit (a) The intersection of the original marginal revenue curve MR0 and the marginal cost curve occurs at point S. Thus, the profit-maximizing quantity is Q0, and the corresponding price on demand curve D0 is P0. The firm is earning a profit because price is above average cost. Profit encourages entry. As a result, the firm s perceived demand curve shifts from D0 to D1, and the marginal revenue curve shifts from MR0 to MR1. The new intersection of MR1 and MC is at U. Now, the profit-maximizing quantity is Q1, and the profit-maximizing price on demand curve D1 is P1. Point V sits right on the average cost curve, so because of entry, the firm is now earning zero profit. CH 12 Taylor: Principles of Economics 3e 9

10 EXHIBIT 12-3 Monopolistic Competition, Entry, and Exit (b) The intersection of the original marginal revenue curve MR0 and the marginal cost curve occurs at point W. Thus, the profit-maximizing quantity is Q0, and the corresponding price on demand curve D0 is P0. The firm is suffering a loss because price is below average cost. Loss leads to exit. As a result, the firm s perceived demand curve shifts from D0 to D1, and its marginal revenue curve shifts from MR0 to MR1. The new intersection of MR1 and MC is at Y. Now, the profit-maximizing quantity is Q1, and the profit-maximizing price on demand curve D1 is P1. Point Z sits right on the average cost curve, so because of exit, the firm is now earning zero profit. CH 12 Taylor: Principles of Economics 3e 10

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12 Monopolistic Competition and Efficiency A monopolistically competitive firm is not productively efficient, because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient, because it does not produce where P = MC, but instead produces where P > MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive firm. CH 12 Taylor: Principles of Economics 3e 12

13 The Benefits of Variety and Product Differentiation Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety. CH 12 Taylor: Principles of Economics 3e 13

14 Oligopoly: The Prisoner s Dilemma and The Oligopoly Version of the Prisoner s Dilemma The prisoner s dilemma is an example of game theory. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for parties is to encourage cooperative behavior. CH 12 Taylor: Principles of Economics 3e 14

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16 Oligopoly (continued) The members of an oligopoly can face a prisoner s dilemma, too. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. But each oligopolist must worry that while it is holding down output, other firms are pursuing their own self-interest by raising output and earning higher profits. But can the two firms trust each other? CH 12 Taylor: Principles of Economics 3e 16

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18 Oligopoly (continued) How can parties who find themselves in a prisoner s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner s dilemma is to find a way to penalize those who do not cooperate. A perceived demand curve that arises when competing oligopoly firms commit to match price cuts, but not price increases. CH 12 Taylor: Principles of Economics 3e 18

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20 Conclusion Competition has many faces. Perfect competition has powerful incentives for efficiency, flexibility, and responsiveness. But the profits to be derived from imperfect competition encourage variety and innovation, whether in the form of monopolistic competition, monopoly, or oligopoly. Moreover, there may be cases like natural monopoly where a monopolist or an oligopoly can produce at a lower price than competition. CH 12 Taylor: Principles of Economics 3e 20