Price-searcher markets with low entry barriers

1
Monopolistic Competition

• 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

2
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.

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

• Advertising increases ATC

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

3
Advertising and Monopolistic Competition

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

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

• Advertising increases ATC

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

16-3
4
McHits or McMisses?
Hulaburger - 1962
Filet o Fish - 1963
Strawberry shortcake - 1966
Big Mac - 1968
Big Mac
Big N Tasty
Big N Tasty w/ Cheese
Quarter Pounder w/ Cheese
Double Quarter Pounder w/ Cheese
Crispy Chicken
Chicken McGrill
Filet-O-Fish
Double Cheeseburger
Cheeseburger
Hamburger
Chicken McNuggets (4)
Chicken McNuggets (6)
Chicken McNuggets (9)
McSalad Shaker Chef Salad
McSalad Shaker Garden Salad
McSalad Shaker Grilled Chicken Caeser Salad
Hot Apple Pie - 1968
Egg McMuffin - 1975
Drive Thru - 1975
Chicken McNuggets - 1983
Extra Value Meal - 1991
McLean Deluxe - 1991
Arch Deluxe - 1996
55-cent Special - 1997
Big Xtra - 1999
McHorseburger - 2003
McRib, Sundaes and others?
5
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
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
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
6
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
7
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.

8
Marginal Revenue similar to Monopoly

• Initial price P1 output q1. Total revenue
  (TR) P1 q1.

Price
1. As price falls from P1 to P2, output
increases from q1 to q2, two conflicting
influences on TR.
P1
1. TR will rise because of an increase in the
number of units sold (q2 - q1) P2.
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).
d

• Depending on the size of the shaded regions,
  total revenue may increase or decrease.

MR
Quantity/time
q2
q1
9
Price and Output Short Run Profit

• A monopolistic competitor maximizes profits by
  producing where MR MC, at output level q

MC
Price
and charges a price P along the demand curve for
that output level.
ATC
P

• At q the average total cost is C.

C

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

d

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

MR
Quantity/time
q
10
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.

11
Price and Output Long Run

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

MC
Price

• When profits (losses) are present, the demand
  curve will shift inward (outward) until the
  zero profit equilibrium is restored.

ATC
P

• 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.

d
MR
Quantity/time
q
12
Profits and Losses
Entry and Exit
Case 1 Prices rise
Profits
Entry or Exit?
Supply
13
SR Profits
1. Increased Demand, Price goes up
2. Firms enter, Demand faced by each firm
decreases
Price
6
ATC
5
MC
4
SR Profits
3
Demand
2
3. Price goes down
1
4. No LR Profits
0
10
20
30
40
50
60
Quantity
14
Profits and Losses
Entry and Exit
Case 2 Prices fall
Profits
Entry or Exit?
Supply
15
SR Losses
1. Demand falls, Price goes down
2. Firms leave, Demand faced by each firm
increases
Price
6
ATC
5
MC
4
Demand
3
SR Losses
2
3. Price goes up
1
4. No LR Losses
0
10
20
30
40
50
60
Quantity
16
Determining Profits Graphically Monopolistic
Competition
P
Profits
MC
ATCLosses
ATCL
ATCBreak even
Losses
ATCProfits
Break even
P
ATCP
A monopolistic firm can earn profits, losses, or
break even in the short run
D
MR
Q
Q
17
Comparing Markets

• 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.

MC
MC
ATC
ATC
P2
d
P1
d
MR
q1
q2
18
Comparing Price Taker Markets

• Even though the two markets have the same cost
  structure, the price in the monopolistic
  competitors market is higher than that in the
  price-takers market ( P2 gt P1 ).
• Some consider this price discrepancy a sign of
  inefficiency others perceive it as a premium
  society pays for variety and convenience (product
  differentiation).

Price
Price
MC
MC
ATC
ATC
P2
d
P1
d
MR
q1
q2
19
Oligopoly
Characteristics?
1. Few Sellers
2. Differentiated or Identical Products
3. Difficult Entry and Exit
4. Non-Price competition
5. LR profits/losses
6. Price Maker
20

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

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

• Oligopolistic firms are mutually interdependent

• Oligopolies can be collusive or noncollusive

• Firms may engage in strategic decision making
  where each firm takes explicit account of a
  rivals expected response to a decision it is
  making

16-20
21
Empirical Measures of Industry Structure

• The concentration ratio is a firms percentage of
  total industry sales

concentration ratio

• The Herfindahl index is the sum of the squared
  value of the a firms share in the industry

Herfindahl index

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

22
Concentration Ratios and the Herfindahl Index
Industry Four Firm Concentration Ratio Herfindahl Index
Poultry 46 773
Soft drinks 52 896
Breakfast cereal 78 2,999
Soap and detergent 38 664
Mens footwear 44 734
Womens footwear 64 1,556
Pharmaceuticals 34 506
Computer equipment 49 1,183
Burial caskets 73 2,965
23
Concentration Ratios and the Herfindahl Index - II
Industry Four Firm Concentration Ratio Herfindahl Index
Cigarettes 99 not disclosed
Sugar refining 99 not disclosed
Copper 95 2,390
Glass containers 91 2960
Beer 90 not disclosed
Small arms ammo 90 not disclosed
Light bulbs 89 2849
Aircraft 85 not disclosed
Motor vehicles 82 2,506
24
Game Theory or Strategic Interaction

• 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

• 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

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

25
Strategies of Players

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

• A dominant strategy is a strategy that is
  preferred by a player regardless of the
  opponents move, prisoners dilemma, for example

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

11-25
26
Strategic Decision Making Models
1. Payoff Matrix
high
low
A
B
59
57
high
55
60
D
C
55
50
low
69
58
27
2. Kinked Demand Curve
price
elastic
Current Price and Quantity
P TR
.
P
inelastic
P TR
DAR
MC1
MC2
MC3
Q
quantity
MR
28
Collusion
Agreement to fix prices and/or divide market
share
- helps reduce uncertainty
- increases profits
- keeps entry difficult
29
Types
1. Overt Collusion
a. Formal Agreement to set Prices
b. OPEC
2. Covert Collusion
a. Secret agreements
b. Electric switch makers in the 50s
30
Auction Markets

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

• 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

31
Types
3. Gentlemens Agreements
a. Agree on price then use non-price competition
b. Types of agreements
1) Price Leadership - GM
-dominant firm set price
-others follow
2) Cost-Plus Pricing
- Set price based on ATC at 85 capacity
32
Obstacles to Collusion
1. More firms, more likely to cheat
2. Firms may cheat in non-price ways free
services
3. Requires barriers to remain high
4. Unstable demand/business cycles
5. Illegal - use Gentlemens agreements
6. Difficult to hold the price
33
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 gt MC P gt MC P gt MC P MC
34
16 Questions
35
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 firms profit?
36
In a monopolistically competitive market, the
firms will a. 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 where a. 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 because a. 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
MC c. P MC
d. MR lt P
37
As long as a market is contestable, then even if
it has only a few sellers, the a. 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 in a. 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.
38
What price should this monopolistically
competitive firm charge in order to maximize
profits?

1. 5 b. 7 c. 8 d. 10

d. 10
What is the maximum economic profit this firm
will be able to earn?
b. 20

1. 0 b. 20 c. 30 d. 100

If 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.
39
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 3 c
. 4 d. 5
At what output would a properly constructed
marginal cost curve cross the ATC
curve? a. 3 b 4 c. 5 d. 6
Calculate 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
40
Which output level would be most closely
associated with the point where diminishing
marginal returns have begun? a 4 b. 5 c. 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.
41

• The graph illustrates a firm
• capable of earning economic profit.
• 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
that a. 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
• fixed cost is higher at a production level of Q1
  than it is at Q3.
• it should produce Q1 units of output.
• c. it should produce Q3 units of output.
• d it should shut down immediately.