• Firms face low entry barriers• Differentiated Products

-they face a downward sloping demand curve-no Long Run Profits-Non-price Competition

• Price Taker• Many Small Firms

Monopolistic Competition

Product Differentiation• Price-searchers produce

differentiated products – products that differ in design, dependability, location, ease of purchase, etc.• Rival firms produce similar products

(good substitutes) and therefore each firm confronts a highly elastic demand curve.

• Advertising increases ATC

• The goals of advertising are to increase demand and make demand more inelastic

• The increase in cost of a monopolistically competitive product is the cost of

“differentness”

Advertising and Monopolistic Competition

• Advertising increases ATC

• The goals of advertising are to increase demand and make demand more inelastic

• Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do

• The increase in cost of a monopolistically competitive product is the cost of

“differentness”

16-3

McHits or McMisses?Hulaburger - 1962Filet o Fish - 1963Strawberry shortcake - 1966Big Mac - 1968Hot Apple Pie - 1968Egg McMuffin - 1975Drive Thru - 1975Chicken McNuggets - 1983Extra Value Meal - 1991McLean Deluxe - 1991Arch Deluxe - 199655-cent Special - 1997Big Xtra - 1999

McRib, Sundaes and others?

Big MacBig N TastyBig N Tasty w/ CheeseQuarter Pounder w/ CheeseDouble Quarter Pounder w/ CheeseCrispy ChickenChicken McGrillFilet-O-FishDouble CheeseburgerCheeseburgerHamburgerChicken McNuggets (4)Chicken McNuggets (6)Chicken McNuggets (9)McSalad Shaker Chef SaladMcSalad Shaker Garden SaladMcSalad Shaker Grilled Chicken Caeser Salad

McHorseburger - 2003

Fish Supreme Chicken Parmesan Sandwich 2/3 lb. Monster Thickburger® 1/3 lb. Low Carb Thickburger®

Little Thick Cheeseburger 1/4 lb. Little Thickburger®

1/3 lb. Cheeseburger Chili Cheese Thickburger®

1/3 lb. Original Thickburger® 1/3 lb. Mushroom 'N' Swiss Thickburger®

1/3 lb. Bacon Cheese Thickburger®

Big Chicken Fillet Sandwich Charbroiled Chicken Club Sandwich Charbroiled BBQ Chicken Sandwich

Big Hot Ham 'N' Cheese™ Regular Hamburger

Regular Cheeseburger Double Cheeseburger

5-Piece Chicken Breast Strips 7-Piece Chicken Breast Strips

Big Shef

Double Jr. Cheeseburger Deluxe

1/4 lb.* Single

1/2 lb.* Double with Cheese

3/4 lb.* Triple with Cheese

Baconator®

Jr. Hamburger

Jr. Bacon Cheeseburger

Jr. Cheeseburger Deluxe

Jr. Cheeseburger

Double Stack

Deluxe Double Stack

Triple Stack

Homestyle Chicken Go Wrap

Grilled Chicken Go Wrap

Spicy Chicken Go Wrap

Crispy Chicken Deluxe

Chicken Club

Ultimate Chicken Grill

Spicy Chicken Sandwich

Homestyle Chicken Fillet

10-piece Chicken Nuggets

Premium Fish Fillet Sandwich

Crispy Chicken Sandwich

Double Jr. Cheeseburger Deluxe

1/4 lb.* Single 1/2 lb.* Double with Cheese

3/4 lb.* Triple with Cheese

Baconator® Jr. Hamburger Jr. Bacon Cheeseburger

Jr. Cheeseburger Deluxe

Jr. Cheeseburger Double Stack Deluxe Double Stack Triple Stack

Homestyle Chicken Go Wrap

Grilled Chicken Go Wrap

Spicy Chicken Go Wrap

Crispy Chicken Deluxe

Chicken Club Ultimate Chicken Grill

Spicy Chicken Sandwich

Homestyle Chicken Fillet

10-piece Chicken Nuggets

Premium Fish Fillet Sandwich

Crispy Chicken Sandwich

Price and Output• A profit-maximizing price searcher

will expand output as long as marginal revenue exceeds marginal cost.• Price will be lowered and output

expanded until MR = MC• The price charged by a price searcher

will be greater than its marginal cost.

d

Price

Quantity/time

P2

P1

MRq1 q2

Increase inTotal Revenue

Reduction inTotal Revenue

Marginal Revenue similar to Monopoly• Initial price P1 & output q1. Total revenue (TR) = P1 * q1.1. As price falls from P1 to P2, output increases from q1 to q2,

two conflicting influences on TR.1. TR will rise because of an increase in the number of units sold (q2 - q1) * P2.2. TR will decline [(P1 - P2) * q1] as q1 units once sold at the higher price (P1) are now sold at the lower price (P2). • Depending on the size of the shaded regions, total revenue may increase or decrease.

d

MR

MC

ATC

Price and Output: Short Run Profit

Quantity/timeq

C

EconomicProfits

• A monopolistic competitor maximizes profits by producing where MR = MC, at output level q and charges a price P along the demand curve for that output level.• At q the average total cost is C.

• Because the price is greater than the average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] * q )

• What impact will economic profits have if this is a typical firm?

Price

P

Profits and Losses in the Long Run• Economic profits attract competition.

• New firms will expand supply and lower price.

• Individual demand curves will shift inward until the economic profits are eliminated.

• Economic losses cause firms to leave the market.• Demand for the remaining firms’ output

will rise until the losses have been eliminated, ending the incentive to exit.

• Firms can make either profits or losses in the short run, but only zero economic profit in the long run.

• Because entry and exit are free, competition will eventually drive prices down to the level of ATC.

Quantity/timeq

P

d

MR

MC

ATC

Price and Output: Long Run

• When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored.• The price searcher establishes its output level where MC = MR.• At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present.

C = P

Price

Entry or Exit?

Supply

ProfitsCase 1: Prices rise

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

Demand

SR Profits

1. Increased Demand, Price goes up2. Firms enter, Demand

faced by each firm decreases

3. Price goes down4. No LR Profits

ATCMC

Entry or Exit?

Supply

ProfitsCase 2: Prices fall

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

Demand SR

Losses

1. Demand falls, Price goes down

ATC2. Firms leave, Demand faced by each firm increases

3. Price goes up4. No LR Losses

MC

Q

P

ATCBreak even

Q

MC

D

MR

A monopolistic firm can earn profits, losses, or break even in the short

run

Determining Profits Graphically: Monopolistic Competition

Losses

Break even

Profits

P

ATCLosses

ATCProfits

ATCL

ATCP

Price

Quantity/Time

Pure Comp Mono compPrice

Quantity/Time

d

MC

ATC

dMR

MC

ATC

P2

q2

P1

q1

• LR equilibrium for both.• P = ATC and there are no economic profits.• In monopolistic competition, firms face a

downward-sloping demand curve, its profit-maximizing price exceeds MC.

• In Monopolistic Competition, output is too small to minimize ATC in long-run equilibrium.

Comparing Markets

Price

Quantity/Time

Pure Comp Mono compPrice

Quantity/Time

d

Price MC

ATC

d

MC

ATC

P2

P1

Price

MRq2q1

• Even though the two markets have the same cost structure, the price in the monopolistic competitor’s market is higher than that in the price-taker’s market ( P2 > P1 ).

• Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation).

Comparing Price Taker Markets

1. Few Sellers2. Differentiated or

Identical Products

Characteristics?

4. Non-Price competition

6. Price Maker

3. Difficult Entry and Exit

5. LR profits/losses

• Oligopolies are made up of a small number of firms in an industry

• Oligopolistic firms are mutually interdependent

• In any decision a firm makes, it must take into account the expected reaction of other firms

• Oligopolies can be collusive or noncollusive• Firms may engage in strategic decision making

where each firm takes explicit account of a rival’s expected response to a decision it is making

16-20

Empirical Measures of Industry Structure

• The concentration ratio is a firm’s percentage of total industry sales

• This gives more weight to firms with large market shares than does the concentration ratio measure

• The Herfindahl index is the sum of the squared value of the a firm’s share in the

industry

concentration ratio

Herfindahl index

Concentration Ratios and the Herfindahl

IndexIndustry

Four Firm Concentration

Ratio Herfindahl IndexPoultry 46 773Soft drinks 52 896Breakfast cereal 78 2,999Soap and detergent 38 664

Men’s footwear 44 734Women’s footwear 64 1,556Pharmaceuticals 34 506Computer equipment 49 1,183

Burial caskets 73 2,965

Concentration Ratios and the Herfindahl

Index - IIIndustry

Four Firm Concentration

Ratio Herfindahl IndexCigarettes 99 not disclosedSugar refining 99 not disclosedCopper 95 2,390Glass containers 91 2960Beer 90 not disclosedSmall arms ammo 90 not disclosedLight bulbs 89 2849Aircraft 85 not disclosedMotor vehicles 82 2,506

Game Theory or Strategic Interaction

• Cooperative games are games in which players can form coalitions and can enforce the will of the coalition on its members

• Sequential games are games where players make decisions one after another, chess, for

example

• A non-cooperative game is a game in which each player is out for him- or herself and agreements are either not possible or not

enforceable

• Simultaneous move games are games where players make their decisions at the same time as other players, for example, the

prisoner’s dilemma

Strategies of Players

• A dominant strategy is a strategy that is preferred by a player regardless of the opponent’s move, prisoner’s dilemma, for example

• A mixed strategy is a strategy of choosing randomly among moves, for example, rock,

paper, scissors

• In backward induction, you begin with a desired outcome and then determine the decisions that could have led you to that

outcome

11-25

D

A B

C

high

high

low

low

$57

$55

$55

$60

$59

$50$69 $58

price

quantity

D=AR

Current Price and

Quantity

MR

elastic

inelastic

P TR

P TRMC1

MC2MC3

Q

P

a. Formal Agreement to set Prices

b. OPEC

1. Overt Collusion

a. Secret agreements2. Covert Collusion

b. Electric switch makers in the 50s

• Vickrey auctions are a sealed bid auction where the highest bidder wins but pays the price bid by the next highest bidder

• Vickrey auctions result in higher bids because people are more likely

to bid their willingness to pay

• Standard sealed bid auction is where the person who bids the highest gets the good

Auction Markets

a. Agree on price then use non-price competition

b. Types of agreements

3. Gentlemen’s Agreements

2) Cost-Plus Pricing

1) Price Leadership - GM

- Set price based on ATC at 85% capacity

-dominant firm set price-others follow

2. Firms may cheat in non-price ways – free services

3. Requires barriers to remain high

1. More firms, more likely to cheat

5. Illegal - use Gentlemen’s agreements

4. Unstable demand/business cycles

6. Difficult to hold the price

Comparison of Market Structures

Monopoly Oligopoly Monopolistic Competition

Perfect Competition

No. of firms One Few Many Almost infinite

Barriers to entry Significant Significant Few None

Pricing decisions MC = MR Strategic pricing MC = MR MC = MR = P

Output decisions Most output restriction

Output restricted

Output restricted, product

differentiation

No output restriction

Interdependence No competitors

Interdependent decisions

Each firm independent

Each firm independent

LR profit Possible Possible None None

P and MC P > MC P > MC P > MC P = MC

Right after you graduate, you get a job in production management and you are responsible for the entire company on weekends.Here are the costs of production for the company:

Quantity Average Total Cost 500 $200 501 $201

Your current level of production is 500 units and all 500 have been ordered by regular customers.

One weekend, the phone rings. It is a customer who wants to buy one unit of your product. This means increasing production to 501 units. The customer offers to buy it for $450.Should you accept the offer?What is the net change in the firm’s profit?

In a monopolistically competitive market, the firms willa. be able to choose their price, and the entry barriers into the market will be low.b. be able to choose their price, and the entry barriers into the market will be high.c. have to accept the market price for their product, and the entry barriers into the market will be low.d. have to accept the market price for their product, and the entry barriers into the market will be high.A profit-maximizing MC firm will expand output to the point wherea. total revenue equals total cost. b. marginal revenue equals marginal cost.c. price equals average total cost. d. price equals marginal cost.In the long run, neither perfectly competitive nor monopolistically competitive firmswill be able to earn economic profits becausea. entry barriers into these markets are high, raising the costs of each firm.b. the government will dictate moderate prices for these firms.c. competition will force prices down to the level of per-unit production costs.d. marginal revenue is always less than marginal cost when barriers to entry are low.If a market is in long-run equilibrium, which of the following conditions will be present in a monopolistically competitive market but absent from a perfectly competitive market?a. P = ATC b. MR = MCc. P = MC d. MR < P

As long as a market is contestable, then even if it has only a few sellers, thea. threat of new firms will prevent the prices from rising above the competitive level.b. producers will be able to charge prices that are high enough to produce long-run economic profits.c. producers will not face new competition because the barriers to entry are high.d. market will never be expected to come close to the competitive result.If firms in a monopolistically competitive market are currently earning economic losses, then in the long run,a. new firms will enter the market, and the current firms will experience a decrease in demand for their products until zero economic profit is again restored.b. new firms will enter the market, and the current firms will experience an increase in demand for their products until zero economic profit is again restored.c. some existing firms will exit the market, and the remaining firms will experience an increase in demand for their products until zero economic profit is again restored.d. some existing firms will exit the market, and the remaining firms will experience a decrease in demand for their products until zero economic profit is again restored.Compared to the outcome when the firms are price takers, monopolistically competitive markets will result ina. a wider variety of products and higher prices.b. less product variety and higher prices.c. a wider variety of products and lower prices.d. less product variety and lower prices.

What price should this monopolistically competitive firm charge in order to maximize profits?a. $5 b. $7 c. $8 d.

$10What is the maximum economic profit this firm will be able to earn?a. $0 b. $20 c. $30 d.

$100If these are cost and demand conditions of this firm, what will happen in the future?a. Firms will go out of business, and the market price will rise.b. The current market price will tend to persist into the future.c. New firms will enter the market, and demand facing this firm will decline.d. The firms in this industry probably will collude in order to increase their profitability.

d. $10

b. $20

The average variable cost (AVC) and average total cost (ATC) for a firm are shown here. If the marginal cost curve were constructed, at what output would it cross the AVC curve?

a. 2 b 3c. 4 d. 5

At what output would a properly constructed marginal cost curve cross the ATC curve?a. 3 b 4 c. 5 d. 6Calculate the total cost of producing four units.a. $10 b. $15 c $60 d. $75

Calculate the total variable cost of producing three units.a. $10 b. $15 c. $30 d. $45

Which output level would be most closely associated with the point where diminishing marginal returns have begun?a 4 b. 5c. 6 d. 8

Which output minimizes per-unit cost?a. 4 b. 6 c. 7 d 8

Which of the following is true?a. Firms in this industry begin to experience diminishing returns to their variable factors at output q1.b. Between q1 and q2, firms in this industry experience economies of scale.c Firms producing output rates less than q1 or more than q2 will find it difficult to survive.d. The largest firms in this industry have the lowest per-unit cost.

The graph illustrates a firma.capable of earning economic profit.b.that is only able to break even when it maximizes profit.c taking economic losses.d. that should shut down immediately.

When price rises from P2 to P3, the firm finds thata. marginal cost exceeds marginal revenue at a production level of Q2.b. if it produces at output level Q3 it will earn a positive profit.c expanding output to Q4 would leave the firm with losses.d. it could increase profits by lowering output from Q3 to Q2.When price falls from P3 to P1, the firm finds that

a.fixed cost is higher at a production level of Q1 than it is at Q3.b. it should produce Q1 units of output.c. it should produce Q3 units of output.d it should shut down immediately.