The final module of the Power of Markets course begins by further exploring firm behavior in imperfectly competitive market settings: how firms with monopoly power can increase profits through price discrimination; and the price-output combinations we can expect firms to select in cases of monopolistic competition and oligopoly. We will also analyze monopolies from an efficiency perspective and look at the effects of imperfect information on firm and consumer behavior. We will next turn to exploring input markets and what determines the demand for an input by a firm, an industry, and the overall market. We will also look at the factors that affect input supply and how the supply of an input interacts with demand to determinant input prices. We will use input market theory to analyze institutions and government policies such as the NCAA sports cartel, the minimum wage, Social Security, and immigration. Finally, we will address the concept of market efficiency and what government can do to promote it as well as how government intervention may diminish it.
Monopolistic Competition
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From the course by University of Rochester
The Power of Markets III: Input Markets and Promoting Efficiency
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From the lesson
Week 9 - Product Pricing With Monopoly Power
Price Discrimination. Firm Behavior in Cases of Monopolistic Competition and Oligopoly.
Meet the Instructors
Mark ZupanProfessor of Economics and Public Policy
Simon School of Business
Welcome back. In these next few sessions,
we'll look at cases in between perfect competition and pure monopoly.
We'll look first to monopolistic competition.
Cases where we have open entry,
many different suppliers,
but the ability of individual suppliers to differentiate their products.
Think about refractive eye surgery,
and the different ways that you can get your vision corrected
whether it's with systems like PRK or LASIK eye surgery.
Or think about the fast food business where there are
different suppliers of fast food and yet,
the Burger King Whopper is still differentiated in the eyes of consumers,
for many consumers, with the McDonald's cheeseburger or Big Mac.
So, what will happen in these settings?
Is government intervention warranted?
Is efficiency served?
We'll take a look at them.
Again there may be real differences between
the products or there may be perceived differences.
In blind taste test,
many consumers can't tell the difference between Coke and Pepsi.
And yet, those perceived differences it can still give rise to monopolistic competition.
There may be differences in where
different restaurants serve shops are located that provide
the differentiating advantage or the quality of service that
one establishment touts versus the other.
Let's look at what monopolistic competition means.
In the short run, it's possible to make profits.
And each firm because it is able to differentiate its product,
has a downward sloping demand curve,
as in panel A and an associate marginal revenue curve.
And that firm by following the marginal cost,
comparing marginal cost to marginal revenue,
charging a price of P1,
is able to make money.
The profit is the shaded blue area.
But because monopolistic competition assumes the possibility of entry,
and numerous potential competitors,
the prediction of where we'll end up in the long run is profits equal to zero.
The demand curve for each firm shrinks sufficiently through entry in competition,
that at the point where marginal revenue equals marginal cost,
output Q2, the price that
the monopolistic competitor charges exactly offsets average cost.
So no profits in the long run.
Now there are two deadweight losses,
two strikes that are typically cited against monopolistic competition.
The first one is,
that you're not producing at minimum efficient scale.
Average costs are higher than they need to be.
If there were fewer number of firms producing
at the lowest possible point on the average cost curve,
overall industry costs conceivably could be lower.
And second, because price is above marginal cost,
there is a deadweight loss associated with
that output being less than the efficient output level.
And conceivably, by looking at the demand curve for this monopolistic competitor,
what we'd want to do is compare output where price exceeds marginal cost,
and then add up all the units,
the difference between what people are willing to pay for
this product relative to the marginal cost of producing it.
So, we could say there's also a deadweight loss that's equal to ACB, triangular area ACB.
Now, that deadweight loss overstates
the true deadweight loss of monopolistic competition.
Why? Because let's assume that as we're expanding output,
this firm is just one of many.
So what if we looked at the overall expansion of
output of across all firms in the industry?
And let me erase what I've just drawn, go back.
So, this is where the D-Star curve comes in.
The demand curve when we take into account
the overall expansion of the industry as we move for each firm out from Q,
is less price elastic.
Why? Because if this firm seeks to decrease price,
the amount by which its output will expand,
will not be as large.
We'll just be out to this D-Star curve compared
to a case where other firms in
the monopolistic competitive industry wouldn't expand output.
So the true deadweight loss will be a smaller area when we take into account
the expansion of the entire industry and looking
at what the true deadweight loss is if we scale up output in this industry.
So the deadweight loss is a smaller area, triangular area ARB.
Now, is government intervention warranted?
Potentially. But weighed against that potential benefit of
government intervention are the benefits of product differentiation.
One also has to take into account what the costs are associated with
potential regulation and will
there be an impact on the quality of the goods offered for sale.
The profit margins tend to be small in a monopolistic competitive industry.
So if the individual price elasticity is 10 or 15,
if you use the inverse elasticity rule,
you'll figure out that the markup of price over marginal cost will tend to
be pretty small on the order of a 7 percent or so, or even lower.
And indeed when we look at a case like the fast food industry,
margins tend to be on the order of 4%.
This an industry that accounts for 4% of gross domestic product.
60% of the firms fail in this industry within three years,
25% within one year,
and the margins on average are a 5.4%.
So, a lot of variety but very low margins.
Same thing we're finding in refractive eye surgery.
Initially, when this industry was developing people were charging
as much as $3,000 per eye to correct your vision.
Now the price has fallen to $300 and the margins have
come down drastically from what we would have seen 5, 10 years ago.
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