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Monopolistic Competition and

 On one extreme is the Perfect Competition model

 On the other extreme is the Monopoly Model

 Monopolistic Competition & Oligopoly are competitive

scenarios that lie between these two extremes

 Therefore, competitive features of Monopolistic

Competition and Oligopoly will emulate either Perfect
Competition or Monopoly
Characteristics of Monopolistic
 Power to set prices somewhat like a monopoly
 Face competition like perfect competition
 Large number of firms
-- Each firm has relatively small market share
-- Each firm must be sensitive to average market price of
its product
-- Collusion is not possible due to the number of firms
 No barriers to entry or exit
Characteristics of Monopolistic
 Product Differentiation – Each firm makes a product that
is slightly different from the products of competing firms.
-- Close substitutes but no perfect substitutes
-- An attempt to increase price will normally results in a
lower volume sold
 Competition on Quality, Price, Marketing
-- Quality is design, reliability, service provided to buyer
and ease of access to product
-- Price – downward sloping demand curve
-- Marketing – firm must market = promotion,
distribution, packaging
Product Differentiation

 Product differentiation is crucial to

monopolistic competition
 People value variety, even if it is not material
 Product differentiation takes place in buyer’s
 Americans are provided with a wide variety of
products and services
 Variety is valued but costly – we pay for it
The Typical Monopolistic Competitor

 The monopolistic competitor tries to set

his or her product apart from the
 The main way of doing this is through
 When this is done successfully, the demand
curve becomes more vertical or inelastic
 Buyers are willing to pay more for a product or
service because they believe it is much better
than their other choices

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 24-14
Basis for Product Differentiation
 Physical differences
 Convenience
 Ambience
 Reputations
 Appeals to vanity
 Unconscious fears and desires
 Snob appeal
 Customized products
Product Differences

 Product differentiation does not necessarily

mean there are any physical differences
among products
 They might all be the same, but how they are sold
may make all the difference

 There are, of course, some very real

physical product differences.
 Buyers often differentiate based on real physical
differences, but differentiation is still taking place
in the buyers mind, and it may or may not be
based on real physical differences

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 24-16
Advertising and Branding
 What’s to be gained by pouring money into
advertising? It works!
-- Continuous signals regarding product
-- coca-cola vs pepsi
 Brand has tremendous value
-- e.g. Budweiser
-- Brands tend to capture in a single name all
the values a firm wants to impress upon the
The Typical Monopolistic Competitor
 Tries to set his firm apart from his competition
-- New Product Development and Innovation
1. Striving to maintain an economic profit
-- Advertising
1. Create consumer perception of product
differentiation – real or imagined
2. Attempting to keep demand as inelastic as
 Selling costs can be extremely high
Identifying Monopolistic Competition
 How much is the industry dominated or not dominated
by few suppliers
-- geographical scope – national, regional, global
An industry can be almost perfectly competitive
on a national scope, but almost a monopoly locally
e.g. Concrete Mixing
-- Barriers to entry and exit – industries may appear
concentrated but few barriers exist to prevent entry:
e.g a community with only one restaurant-
there is no barrier to other restaurants coming in
Identifying Monopolistic Competition
 The four-firm concentration ratio – The
percentage of the value of total market
revenue accounted for by the four largest firms
in the industry
-- A low concentration ratio indicates a high
degree of competition
-- A high concentration ratio indicates an
absence of

Identifying Monopolistic Competition
 The Herfindahl-Hirschman Index – the square of the
percentage market share of each firm summed over the
largest 50 firms in the industry (or all of the firms if there
is less than 50)
-- In perfect competition, the HHI is small
-- In monopoly, the HHI is 10,000 (100 squared)
-- A popular measure with the Justice Dept in the 1980’s
HHI < 1000 characterized competitive markets
HHI > 1800 would bring Justice Dept challenge
to proposed mergers

Examples of Monopolistic
Banks Sporting Goods
Radio Stations Fish and Seafood
Clothing Jewelry
Computers Health Spas
Frozen Foods Apparel Stores
Canned Goods Soaps & Shampoos
Convenience Stores Toothpaste

Price Discrimination
 Question – Does price discrimination raise or
lower profit?
 Price discrimination – selling the same good or
service at a number of different prices.
Basically an illegal activity under the
Clayton Act
unless there is a cost justification for the
 Answer – Price discrimination is a marketing
means to increase economic profit
Price Discrimination
 Methods of price discrimination
-- Discriminate among groups of buyers
works when different buying groups are
to pay different prices (on the average) for
the same good or service
Example: Airline travel – prices target
business travelers vs leisure time travelers
-- discriminator is advance notice, shorter
the notice, the higher the price
Some Examples of Price
Doctors often charge rich patients more than
poor patients
 They may have one price for those with insurance
and another price for those without insurance
Movies in the evening cost more than those
in the early afternoon
Senior citizen, youth, and student discounts
New and used cars
Youth fairs on airlines
Evening meals in restaurants often cost
more than the same meal at lunch

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 24-18
Practicing Price Discrimination

 The firm that practices price

discrimination must be able to distinguish
between two or more separate groups of

 Price discriminators must also be able to

prevent buyers from reselling the product
or service
 For example, if a fifteen-year-old could resell his
youth fare seat to an adult who could then use
it, the price discrimination effort would fail

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 24-19
Motives for Price Discrimination

 In most cases, price discrimination is

basically a mechanism for rationing goods
and services

 The main motivation for price discrimination

is to raise profits
 The greater the price discrimination, the greater
the profits because buyers lose some of their
“consumer surplus”
 If price discrimination were carried to its logical
conclusion, we would have perfect price
 The buyers would lose all of their “consumer surplus”

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 24-20
Price Discrimination
 Methods of discrimination
-- Discriminate among units – firm charges the
same price to all customers but there are
volume discounts

 The key idea is to figure a way to charge those

incremental buyers who are willing to pay more
a higher price

 Result – Consumer Surplus is converted to

Producer Surplus
Price Discrimination
 Perfect Price discrimination occurs when a firm
figures out how to extract the entire consumer

 Once the firm has the entire consumer surplus,

the MR curve becomes the Demand Curve

 At that point, the firm extracts even more

economic profit by increasing production to the
point where
MR(D) = MC
Is the Monopolistic Competitor
 From a purely economic standpoint . . .Yes!
 The firms do not produce at the minimum point on the
 There may be too many firms in most industries
 Are there too many beauty parlors? Not if you want to get
your hair done on Friday afternoon or Saturday morning
 Are there too many restaurants? Not on Sunday
 There may be overdifferentiation
 Would Americans want the drab businesses that
characterize eastern Europe and the old soviet union?
 Would Americans want only one brand of toothpaste or
one brand and model of a car?
 In America, it would be hard to imagine a no-frills

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 24-23
Closing Thoughts

 More than 99% of the over 23 million business

firms in the United States are monopolistic

 While price competition exists, they compete

more vigorously over differentiation
characteristics such as ambience, service,
convenience, quality, brand awareness, etc.