17 Monopolistic Competition and Advertising

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CHAPTER OUTLINE

Sources of Product Differentiation

The Monopolistic Competition Model

The Economics of Advertising

Takeaway

You can find a mystery at Amazon.com. In fact, you can find 2,530 mysteries, including novels by Janet Evanovich, Stephen King, and James Patterson. What we have in mind, however, is a different but closely related economic puzzle or mystery.

In some ways, the market for books appears to be very competitive. There are lots of choices and very few barriers to entry. Authors today, for example, don’t even need access to an expensive printing press because they can “print” their books electronically and sell them on Amazon alongside books from established publishers like HarperCollins. Yet even though the market appears competitive, prices are above marginal cost. It doesn’t cost $18 to print the latest Stephen King novel, even including delivery, and it certainly doesn’t cost $14.99 to deliver the book electronically to a Kindle or iPad. Why are prices higher than marginal cost in a market with lots of choices and few barriers to entry?

In other ways, however, the market for books looks like a monopoly. Anyone can sell mysteries but only Stephen King can sell Stephen King novels. In fact, copyright law makes it a crime for anyone else to sell a Stephen King novel until 70 years after his death! Thus, there is a significant barrier to entry for selling Stephen King novels. True, it is legal to write and sell mysteries in the style of Stephen King but many readers find that Stephen King substitutes are just not as horrifying as the real thing. As a result, Stephen King faces a downward-sloping demand curve and he is not forced to price at marginal cost.

Monopolistic competition is a market with a large number of firms selling similar but not identical products.

In this chapter, we will be looking at a type of market structure that combines some features of competitive markets with some features of monopoly, namely monopolistic competition. Monopolistic competition describes a market with the following features:

Many sellers: There are lots of firms in the market and lots of potential firms.

Free entry: Firms can enter or exit the market without restriction. As a result, firms will enter when P > AC and exit when P < AC so, just as with competitive markets, in the long run profits are driven to zero (normal) with P = AC.

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Product differentiation: Each firm produces a product that is somewhat different from its competitors. Thus, each firm faces a downward-sloped demand curve.

Perfectly competitive markets also feature many sellers and free entry so what makes monopolistic competition different is the final feature, product differentiation. Recall our example of a perfectly competitive market, the market for oil. If you owned a small oil well, you would face a perfectly elastic demand curve because one seller’s oil is pretty much the same as another seller’s oil. As we said in Chapter 11, even your mother probably wouldn’t pay extra for your oil.

But instead of owning a small oil well, suppose you owned a small restaurant. There are many sellers in the restaurant business and there is free entry, but the food in your restaurant will probably be a little bit different from the food in other restaurants. Indeed, some of your customers might be willing to pay a bit extra to eat in your restaurant compared to the next best substitute. As a small restaurant owner, if you raise your prices a little, you will lose some but not all of your customers, and if you lower prices a little, you will sell more but you won’t suddenly find yourself with lines out the door. In other words, unlike the owner of a small oil well, as a small restaurant owner, you would face a downward-sloping demand curve.