Chapter 25 - Monopolistic Competition.doc

380Miller•Economics Today, Nineteenth Edition Chapter 25Monopolistic Competition379 Answers to Questions for Critical Analysis When a Drink’s Taste Is Not Sufficiently Distinguishable, Try a Flavored Edible Straw (p. 561) Why might serving drinks with uniquely flavored edible straws assist a restaurant in distinguishing its products from competitors’ products with similar tastes and textures? The uniquely flavored edible straws add different tastes to the restaurant’s products and thus make these products more distinguishable from its competitors’ products. Want to Start a Kids” TV Network? Bring Back Old Cartoon Characters? (p. 562) Why do you suppose that companies such as Amazon and Netflix have also entered the children’s TV programming industry by streaming kids’ shows online? Companies such as Amazon and Netflix have already entered the video industry, so that they will not incur as much the required capital cost to operate in the children’s TV programming industry as others. Do Business Schools’ Uses of Their Rankings Inform or Persuade? (p. 568) Why do you suppose that business schools with weaker programs typically display their category ratings on billboards, whereas those with stronger programs usually do not place ads on billboards at all? Business schools with weaker programs are not as well-known as their counterparts with stronger programs. Hence, they typically display their category ratings on billboards as a way to engage in persuasive advertising intended to induce a prospective student to discover previously unknown information about the business schools. Business schools with stronger programs, by contrast, engage in informational advertising by emphasizing information about the specific features of their programs. You Are There A Soft Drink Company Faces Another Entity into an Already Crowded Industry (p. 572) 1. Other things being equal, how did the entry of Keurig into this industry likely initially affect the demand for items produced and sold by SodaStream? The entry of Keurig initially reduced the demand for items produced and sold by SodaStream. 2. How were SodaStream’s responses discussed above likely intended to affect the demand for its products following Keurig’s entry into the industry? By adding more differentiated products, SodaStream’s responses would likely raise the demand for its product. Issues and Applications Professional Service Firms Confront Easier Entry by New Competitors (pp. 572–573) 1. If efforts by traditional financial-planning firms to promote their financial therapy services prove successful, what will happen to the positions of and shapes of the demand curves that they face? Explain. If the traditional financial-planning firms’ financial therapy services become successful, their demand curves shift to the right. In addition, the demand curves will become steeper due to more differentiation of the firms’ services. 2. How has the entry of the legal divisions of commercial accounting firms into the market for legal services likely affected the positions and shapes of the demand curves faced by incumbent commercial law firms? The entry of legal divisions of commercial accounting firms into the market for legal services would likely reduce the demand for incumbent commercial law firms. Hence, the incumbent commercial law firms’ demand curves would shift to the left and become less steep as a result of increased market competition. Research Project 1. Learn more about the financial therapy approach to the provision of personal financial-planning services in the Web Links in MyEconLab. 2. To learn more about the push into the legal-services market by divisions of commercial accounting firms, see the Web Links in MyEconLab. Answers to Problems 25-1. Explain why the following are examples of monopolistic competition. a. There are a number of fast-food restaurants in town, and they compete fiercely. Some restaurants cook their hamburgers over open flames. Others fry their hamburgers. In addition, some serve broiled fish sandwiches, while others serve fried fish sandwiches. A few serve ice cream cones for dessert, while others offer frozen ice cream pies. b. There are a vast number of colleges and universities across the country. Each competes for top students. All offer similar courses and programs, but some have better programs in business, while others have stronger programs in the arts and humanities. Still others are academically stronger in the sciences. a. There are many fast-food restaurants producing and selling differentiated products. Both of these features of this industry are consistent with the theory of monopolistic competition. b. There are numerous colleges and universities, but each specializes in different academic areas and hence produces heterogeneous products, as in the theory of monopolistic competition. 25-2. Consider the diagram below depicting the demand and cost conditions faced by a monopolistically competitive firm. a. What are the total revenues, total costs, and economic profits experienced by this firm? b. Is this firm more likely in short- or long-run equilibrium? Explain. a. The firm maximizes profits by producing to the point at which marginal revenue equals marginal cost, at 100 units per day. Its profit-maximizing price is $28 per unit, so its total revenues equal $2,800 per day. Its average total cost is $28 per unit, so its total costs equal $2,800 per day. Consequently, its economic profits equal $0 per day. b. Although it is possible that this is a short-run equilibrium situation, it is more likely, given that economic profits are zero, that this is a long-run equilibrium in which price equals average total costs, and there is no incentive for firms to enter or leave the industry. 25-3. In a perfectly competitive market, price equals marginal cost, but this condition is not satisfied for the firm with the revenue and cost conditions depicted in Problem 25-2. In the long run, what would happen if the government decided to require the firm in Problem 25-2 to charge a price equal to marginal cost at the firm’s long-run output rate? If the firm had to reduce its price from the long-run equilibrium level of $28 per unit to marginal cost at $20 per unit, its revenues would drop from $2,800 per day for the long-run output rate of 100 units to $2,000 per day. Thus, it would experience a daily economic loss of $800 per unit and eventually choose to exit the industry rather than continue producing at a loss. 25-4. Based on your answer to Problem 25-3, is the firm with the revenue and cost conditions depicted in Problem 25-2 behaving “anticompetitively” in the sense of intentionally “taking advantage” of consumers by charging them a price greater than marginal cost? Explain your reasoning. There is no definite “right” or “wrong” answer to this question, which has long bedeviled economists. On one hand, the fact that price exceeds marginal cost can be interpreted as meaning that by definition monopolistically competitive firms behave in an “anti-perfectly-competitive” manner. On the other hand, in a long-run monopolistically competitive situation such as displayed in Problem 25-2, it is impossible for a firm to earn at least zero economic profits unless price exceeds marginal cost. Thus, some economists view the above-marginal-cost price as one that consumers must pay for the “differentness” of the item produced by a monopolistically competitive firm. 25-5. The table below depicts the prices and total costs a local used-book store faces. The bookstore competes with a number of similar stores, but it capitalizes on its location and the word-of-mouth reputation of the coffee it serves to its customers. Calculate the store’s total revenue, total profit, marginal revenue, and marginal cost at each level of output, beginning with the first unit. Based on marginal analysis, what is the approximate profit-maximizing level of output for this business? Output Price per Book ($) Total Costs ($) 0 6.00 2.00 1 5.75 5.25 2 5.50 7.50 3 5.25 9.60 4 5.00 12.10 5 4.75 15.80 6 4.50 20.00 7 4.00 24.75 The values for marginal cost and marginal revenue appear below. Marginal revenue equals marginal cost at approximately the fifth unit of output, so marginal analysis indicates that 5 units is the profit-maximizing production level. Output Price ($ per Unit) Total Costs ($) Total Revenue ($) Marginal Cost ($ per unit) Marginal Revenue ($ per unit) Total Profit ($) 0 6.00 2.00 0.00 — — ?2.00 1 5.75 5.25 5.75 3.25 5.75 0.00 2 5.50 7.50 11.00 2.25 5.25 3.50 3 5.25 9.60 15.75 2.10 4.75 6.15 4 5.00 12.10 20.00 2.50 4.25 7.90 5 4.75 15.80 23.75 3.70 3.75 7.95 6 4.50 20.00 27.00 4.20 3.25 7.00 7 4.00 24.75 28.00 4.75 1.00 3.25 25-6. Calculate total average costs for the bookstore in Problem 25-5. Illustrate the store’s short-run equilibrium by plotting demand, marginal revenue, average total costs, and marginal costs. What is its total profit? Expanding the table in Problem 24-3 yields the following values for average total cost and profit. Maximized profit at five units of production is $8.95. Output Price ($ per Unit) Total Costs ($) Average Total Costs ($ per unit) Total Revenue ($) Total Profit ($) Marginal Cost ($ per unit) Marginal Revenue ($ per unit) 0 6.00 2.00 — 0.00 -2.00 — — 1 5.75 5.25 5.25 5.75 0.50 3.25 5.75 2 5.50 7.50 3.75 11.00 3.50 2.25 5.25 3 5.25 9.60 3.20 15.75 6.15 2.10 4.75 4 5.00 12.10 3.03 20.00 7.90 2.50 4.25 5 4.75 15.80 3.16 23.75 7.95 3.70 3.75 6 4.50 20.00 3.33 27.00 7.00 4.20 3.25 7 4.00 24.75 3.54 28.00 3.25 4.75 1.00 25-7. Suppose that after long-run adjustments take place in the used-book market, the business in Problem 25-5 ends up producing 4 units of output. What are the market price and economic profits of this monopolistic competitor in the long run? After these long-run adjustments have occurred, the demand curve will have shifted to tangency with the average total cost curve at 4 units of output. At this production level, average total cost is $3.03, so this will be the long-run equilibrium price. Because price and average total cost will be equal, the firm will earn zero economic profits. 25-8. It is a typical Christmas electronics shopping season, and makers of flat-panel TVs are marketing the latest available models through their own Web sites as well as via retailers such as Best Buy and Wal-Mart. Each manufacturer offers its own unique versions of flat-panel TVs in differing arrays of shapes and sizes. As usual, each is hoping to maintain a stream of economic profits earned since it first introduced these most recent models late last year or perhaps just a few months before Christmas. Nevertheless, as sales figures arrive at the headquarters of companies such as Dell, Samsung, Sharp, and Sony, it is clear that most of the companies will end up earning only a normal rate of return this year. a. How can makers of flat-panel TVs earn economic profits during the first few months after the introduction of new models? b. What economic forces result in the dissipation of economic profits earned by manufacturers of flat-panel TVs? a. The introduction of new models induces increased demands for the new brands of flat-panel TVs at the various retailers, so the price of each firm’s brand rises above average total cost in the short run, and firms earn positive economic profits. b. Short-run economic profits induce new manufacturers of novel flat-panel TVs to enter the industry, and as this entry occurs, the demands for flat-panel TVs of existing manufacturers decline. As this occurs, the price of each firm’s brand falls toward average total cost, so that in the long run, firms earn zero economic profits. 25-9. Classify each of the following as an example of direct, interactive, and/or mass marketing. a. The sales force of a pharmaceutical company visits physicians’ offices to promote new medications and to answer physicians’ questions about treatment options and possible side effects. b. A mortgage company targets a list of specific low-risk borrowers for a barrage of e-mail messages touting its low interest rates and fees. c. An online bookseller pays fees to an Internet search engine to post banner ads relating to each search topic chosen by someone conducting a search. In part, this helps promote the bookseller’s brand, but clicking on the banner ad also directs the person to a Web page displaying books on the topic that are available for purchase. d. A national rental car chain runs advertisements on all of the nation’s major television networks. a. interactive b. direct c. mass and interactive d. mass 25-10. Classify each of the following as an example of direct, interactive, and/or mass marketing. a. A cosmetics firm pays for full-page display ads in a number of top women’s magazines. b. A magazine distributor mails a fold-out flyer advertising its products to the addresses of all individuals it has identified as possibly interested in magazine subscriptions. c. An online gambling operation arranges for popup ads to appear on a digital device’s screen every time a person uses a media player to listen to digital music or play video files, and clicking on the ads directs an individual to its Web gambling site. d. A car dealership places advertisements in newspapers throughout the region where potential customers reside. a. mass b. direct c. mass and interactive d. mass 25-11. Categorize each of the following as an experience good, a search good, or a credence good or service, and justify your answer. a. A heavy-duty filing cabinet b. A restaurant meal c. A wool overcoat d. Psychotherapy a. Search good. Given the knowledge that it is a heavy-duty filing cabinet, a photo and description providing features such as dimensions are sufficient to evaluate the characteristics of a filing cabinet. b. Experience good. A meal must be eaten for its characteristics to be determined. c. Search good. Given the knowledge that the coat is made of wool, a photo and description providing size information are sufficient to evaluate the characteristics of the coat. d. credence good. Psychotherapy services have characteristics that are likely to be difficult for consumers lacking expertise to assess without assistance from another health care provider, such as a general practitioner who guides someone experiencing depression in seeking psychotherapy treatment from a psychiatrist. 25-12. Categorize each of the following as an experience good, a search good, or a credence good or service, and justify your answer. a. Services of a carpet cleaning company b. A new cancer treatment c. Athletic socks d. A silk necktie a. Experience good. How well the company’s employees clean a carpet can be assessed only by observing the cleanliness of the carpet after they have concluded work. b. Credence good. The effectiveness of a new cancer treatment is difficult for a typical consumer to assess without the assistance of health care providers possessing expertise that the consumer lacks. c. Search good. A consumer can evaluate the features of athletic socks without actually wearing them while walking, running, or participating in sports. d. Search good. Given knowledge that the necktie is made of silk, a photo and description are sufficient to determine its characteristics. 25-13. In what ways do credence goods share certain characteristics of both experience goods and search goods? How do credence goods differ from both experience goods and search goods? Why does advertising of credence goods commonly contain both informational and persuasive elements? Explain your answers. Consumers may be able to assess certain features of a credence good in advance of purchase, so in this sense a credence good is similar to a search good. Consumers lack expertise to evaluate the full qualities of a credence good until after they have purchased it, which is somewhat analogous to the characteristics of an experience good. Nevertheless, the fact that consumers cannot fully evaluate a credence good’s qualities in advance of purchase makes it different from a search good. Likewise, the inability to be certain, without assistance, of the qualities of a credence good following purchase of the good also distinguishes a credence good from an experience good. The fact that consumers can evaluate certain aspects of a credence good in advance of purchase, as in the case of a search good, explains why ads for credence goods, such as pharmaceuticals, often have informational elements. At the same time, however, the fact that consumers cannot truly evaluate credence goods until after purchase, and even then only with assistance, explains why ads for credence goods also commonly include persuasive elements. 25-14. Is each of the following items more likely to be the subject of an informational or a persuasive advertisement? Why? a. An office copying machine b. An automobile loan c. A deodorant d. A soft drink a. Informational advertising. A copying machine is a search good that provides basic functions, so photos and descriptions providing information are common in advertisements for this good. b. Persuasive advertising. Each lender provides different services that must be experienced to truly evaluate service quality, so this is an experience good, and persuasive advertising methods are most suitable. c. Persuasive advertising. A consumer must use a deodorant to assess its characteristics, so it is an experience good for which persuasive advertising is most likely to be used. d. Persuasive advertising. A soft drink must be consumed to determine its taste, so it is an experience good that most likely will be marketed using persuasive advertising. 25-15. Discuss the special characteristics of an information product, and explain the implications for a producer’s short-run average and marginal cost curves. In addition, explain why having a price equal to marginal cost is not feasible for the producer of an information product. Typically, the fixed costs of producing an information product are relatively high, while average variable cost is equal to a very small per-unit amount. As a consequence, the average total cost curve slopes downward with increased output, and average variable cost equals marginal cost at a low, constant amount irrespective of the quantity produced. For an information product, marginal cost is always below average total cost. Consequently, if price were equal to marginal cost, it would always be less than average total cost, so the producer would always earn short-run economic losses. 25-16. A firm that sells e-books—books in digital form downloadable from the Internet—sells all e-books relating to do-it-yourself topics (home plumbing, gardening, and the like) at the same price. At present, the company can earn a maximum annual profit of $25,000 when it sells 10,000 copies within a year’s time. The firm incurs a 50-cent expense each time a consumer downloads a copy, but the company must spend $100,000 per year developing new editions of the e-books. The company has determined that it would earn zero economic profits if price were equal to average total cost, and in this case it could sell 20,000 copies. Under marginal cost pricing, it could sell 100,000 copies. a. In the short run, what is the profit-maximizing price of e-books relating to do-it-yourself topics? b. At the profit-maximizing quantity, what is the average total cost of producing e-books? a. The firm’s total costs equal total fixed costs of $100,000 plus total variable costs, or $0.50 per unit x 10,000 units = $5,000, or $105,000. The firm earns economic profits equal to $25,000 at this rate of output, so its total revenues equal total costs plus economic profits, or $105,000 + $25,000 = $130,000. Hence, the profit-maximizing price equals total revenues divided by its profit-maximizing price, or $130,000/$10,000 = $13.00 per e-book. b. Average total costs equal total costs divided by quantity, or $105,000/$10,000 = $10.50 per e-book. 25-17. Take a look at panel (a) of Figure 25-1, and assume that it initially applies to a typical firm in a monopolistically competitive industry. Explain how it might be possible for this firm temporarily to find itself in a situation such as that depicted in panel (b) during the process of adjustment from panel (a) to a final long-run equilibrium as shown in panel (c). In panel (a), the typical firm experiences positive economic profits. Substantial entry by new firms could cause demand curves at incumbent firms to shift inward substantially. Price could drop below ATC, as in panel (b), which results in negative economic profits at incumbent firms. Exits by some firms then would raise demand at remaining firms, resulting in zero long-run economic profits in panel (c). 25-18. Take a look at panel (b) of Figure 25-1, and assume that it initially applies to a typical firm in a monopolistically competitive industry. Explain how it might be possible for this firm temporarily to find itself in a situation such as that depicted in panel (a) during the process of adjustment form panel (b) to a final long-run equilibrium as shown in panel (c). In panel (b), the typical firm experiences negative economic profits. Exits by many firms could cause demand curves at incumbent firms to shift outward substantially. Price could rise above ATC, as in panel (a), which results in positive economic profits at incumbent firms. Entrances by some firms then would reduce demand at remaining firms, resulting in zero long-run economic profits in panel (c). 25-19. In what fundamental ways does the monopolistic competitor in panel (b) of Figure 25-2 behave similarly to the perfectly competitive firm in panel (a) in a long-run equilibrium? In what fundamental ways does the monopolistically competitive firm behave differently? Key similarities are that the monopolistically competitive firm faces competition from many other firms, produces to the point at which MR = MC, and has a price equal to the average total cost and hence earns zero economic profits. The key differences are that its demand curve slopes downward because of product differentiation and that its price exceeds MR and the minimum feasible ATC. 25-20. At every point along the AFC curve in Figure 25-4, what is true of the explicit dollar amount of this firm’s total fixed costs at any given point that one might select, such as the three points displayed along the AFC curve in the figure? At every single point on the AFC curve, the total fixed costs are constant and equal to $250,000 irrespective of the firm’s output rate. At the top left point, TFC equals AFC times quantity, or $250,000 per unit times 1 unit = $250,000. At the second point lower down the AFC curve, TFC equals $50 per unit times 5,000 units, or $250,000. At the lower right point, TVC = $5 per unit times 50,000 units, or $250,000. 25-21. Take a look at panel (a) of Figure 25-5. Suppose that during the relevant time period, the firm’s marginal and average variable costs remain unchanged. The firm’s total fixed costs, however, rise from $250,000 to $300,000. If the firm had to set the price of its information product equal to marginal cost, what would be the amount of its economic profit, or loss following the increase in its total fixed costs? Because marginal revenue has remained unchanged, MR = MC at the same output rate of 20,000 units per time period. Hence, the firm’s total revenues and total variable costs both remain equal to $2.50 per unit multiplied by 20,000 units, or $50,000. The firm’s total fixed costs have risen to $300,000, so this is the dollar amount of its economic loss per time period. 25-22. Consider panel (b) of Figure 25-5, in which the ATC curve and associated data are the same-drawn at a slightly different scale, however-as in Figure 25-4. Suppose that the shape of the demand curve faced by the firm in panel (b) changes in such a way that it becomes tangent to the ATC curve at a price of $5 per unit. What will happen to this firm’s long-run output rate and economic profits as a result? The change described in the question implies that the demand curve and marginal revenue curves become much shallower. At a point of tangency of the demand curve with the ATC curve at a $5 price, the output rate that will be consistent with MR = MC will be 50,000 units per time period. At the tangency point, price will equal ATC at $5 per unit, so economic profits will remain equal to zero. Selected References Bain, Joe S., “Relation or Profit-Rate to Industry Concentration: American Manufacturing, 1936–1940,” Quarterly Journal of Economics, August 1951, pp. 293–324. Brozen, Yale, ed., The Competitive Economy, Morristown, NJ: General Learning Press, 1975. Chamberlin, Edward, H., The Theory of Monopolistic Competition, 8th ed., Cambridge, MA: Harvard University Press, 1962. Fellner, William, Competition Among the Few, New York: Knopf, 1950. Kilpatrick, R. W., “Stigler on the Relationship between Industry Profit Rates and Market Concentration,” Journal of Political Economy, May–June 1968, pp. 479–488. MacAvoy, Paul W., et al., “High and Stable Concentration Levels, Profitability and Public Policy: A Response,” Journal of Law and Economics, October 1971, pp. 493–500. Meckling, William H. and Michael C. Jensen, “Reflections on the Corporation as a Social Invention,” Los Angeles International Institute for Economic Research, Reprint Paper 18, November 1983. Robinson, Joan, The Economics of Imperfect Competition, London: Macmillan, 1965. Shepherd, William C., The Economics of Industrial Organization, Englewood Cliffs, NJ: Prentice Hall, 1979. Shudson, Michael, Advertising, The Uneasy Persuasion, New York: Basic Books, 1985. Stigler, George, “Notes on a Theory of Duopoly,” Journal of Political Economy, Vol. XLVIII, 1940, pp. 521–541.