Monopolistic Competition and Advertising

1 CHAPTER 17 Modern Principles of Economics: Monopolistic Competition and Advertising Facts and Tools 1. Though its name can sometimes cause confusion for students, the market structure we call “monopolistic competition” is so named because it has some features of monopoly and some features of competition. a. In what ways is a monopolistically competitive market like a monopoly? In what ways is it like competition? b. Which of the outcomes of monopolistically competitive markets is a direct result of its monopoly-like features? Which outcome is a result of its competitive features? Can you summarize these results, so that they can be applied to product markets in general? Solution 1. a. Monopolistic competition is like a monopoly in that each firm is selling a unique, or differentiated, product, so each firm faces a downward-sloping demand curve. It is like competition in that there are a lot of firms in the market as a result of a lack of barriers to entry. b. Just like a monopoly, a firm in monopolistic competition charges a price that is greater than marginal cost because the demand curve is downward sloping. Just like a firm in perfect competition, a firm in monopolistic competition will earn zero profit in the long run. This is because new entrants will compete away any short-run profits. Generally speaking, we can conclude that differentiated products will be sold at prices higher than marginal cost, but easy entry into markets will drive profits toward zero. 2. In a city like New York, the market for stand-up comedians is likely to be monopolistically competitive. Explain why this is. If the market is monopolistically competitive, then what can be said about prices, output, and profits in this market? Solution 2. Monopolistic competition is a good description of the market for stand-up comedians in a city like New York because there are very many of them, the barriers to entry are very low, and they are all a little different—each has their own style and, hopefully, their own material. Because of this, we would expect the results we normally get in monopolistic competition: Prices will be higher than marginal cost (what’s the marginal cost of letting one more person watch a stand-up routine?), each comedian (or comedy club, depending on the student’s take on the question) will have excess capacity, and profits will be equal to zero in the long run. 2 3. Fill in the blanks with “=,” “<,” or “>” as appropriate to describe the long-run outcome in a monopolistically competitive market. a. MC ____ AC b. P ____ AC c. MR ____ MC d. P ____ MC Solution 3. a. MC < AC b. P = AC c. MR = MC d. P > MC 4. For each of the following items, describe how the market that these sellers participate in resembles monopolistic competition. For bonus points (if your professor agrees), describe briefly the strategies that sellers in the market use in order to differentiate their products. a. New car dealerships b. Real estate agents c. Landscapers Solution 4. a. There are often a lot of new car dealerships in most metropolitan areas, and each has a unique location, sells a unique set of vehicles from specific manufacturers or brands, and offers a unique shopping experience. Dealerships try to differentiate themselves primarily through their service departments, their hours, their customer service philosophy, or their shopping experience. Shopping experience is a big one; it’s becoming more and more common now to find coffee shops, salons, or child care services inside a car dealership! b. There are lots of real estate agents in any market, and they are always clamoring for more customers. They differ from one another in their (geographic or demographic) areas of expertise, the company or broker they work for, the relationships they have with other related vendors, and the extra services they provide. Real estate agents work hard trying to steal and retain customers—they send birthday cards, newsletters, and other communications frequently to try to establish a long-term relationship with a homeowner. c. There are lots of landscapers in any market, and they are always clamoring for more customers. They differ from one another in their areas of expertise, the equipment they use, the relationships they have with other related vendors, and the extra services they provide. Landscapers rely a lot on word of mouth and reputation and may advertise which of your neighbors are already using their services, as a way of implying a recommendation from your neighbor. Thinking and Problem Solving 5. As you read in the chapter, the requirements for an industry to be considered monopolistically competitive are that there are many firms and those firms are producing unique, or differentiated, 3 products. One industry in which we find differentiated products is the recording industry. Not only are there many genres of music (iTunes lists almost 50), but within each genre there are countless artists, as well. Over the past few decades, technology has reduced the fixed costs of recording and the marginal costs of distributing music. In 1979, for example, the average studio bill for an album was over $30,000 ($170,000 in today’s dollars). Nowadays, with digital recording technology, an artist or band can record an entire album for a few thousand dollars and the album can be distributed at low cost as MP3s on the Internet, with no record store involved. a. What do you expect to happen to the music industry due to the evolution of much cheaper recording technology? What do you expect to happen to the number of recording artists? b. Suppose there are initially only two recording artists in all of the record industry: the Decemberists (an indie rock band) and Yo-Yo Ma (a famous cellist). How many MP3s will they each be able to sell? Who would buy MP3s from the Decemberists? What about from Yo-Yo Ma? Will anybody buy MP3s from both? c. Now suppose that another artist joins the industry: Isobel Campbell (an indie rock cellist!). What will happen to the demand curves for MP3s that the Decemberists and Yo-Yo Ma face? Will they keep all of their fans? Will they keep any of their fans? What do you think will happen to the total number of MP3s sold in the industry? d. Generally speaking, as technology makes it cheaper and cheaper to produce MP3s, and as more and more bands join the music industry, what will happen to the total number of MP3s downloaded by music fans? What will happen to the MP3s sold by each individual band? What will happen to the profits of each band? Solution 5. a. As recording technology becomes cheaper, more bands should enter the market, and profits should fall. b. Because there are so few bands, anyone who likes music at all will have to buy MP3s from either the Decemberists or Yo-Yo Ma, so they will each sell a lot of MP3s. Anyone who likes rock at all will have to buy from the Decemberists; anyone who likes classical music at all will have to buy from Yo-Yo Ma. Some people (in fact, many people) may buy both, because they like different genres of music. c. Isobel Campbell may draw some but not all fans away from the Decemberists and from Yo-Yo Ma. Some people would rather buy Isobel Campbell MP3s than the Decemberists or Yo-Yo Ma MP3s, so they will switch. Others will welcome the opportunity to listen to more music, so they will add Isobel Campbell MP3s to the MP3s they were already going to purchase. Each band will sell fewer after she joins the market, but the total sold in the market should go up. d. As more bands enter the market, the number of MP3s downloaded by music fans will increase, even though the number downloaded from each individual band will decrease. Reduced costs of distributing music will let people experiment with different genres at lower costs. MP3 singles rather than albums become the norm. Profits, as well, will decrease as each band has less “market power” and faces less and less demand for its MP3s. 4 6. In a famous article on advertising, Gary Becker and Kevin Murphy wrote about advertisements that run during television programs: “One can say either that advertising pays for the programming—the usual interpretation—or that programming compensates for the advertising, which is our preferred interpretation.” Viewing ads during a television program (or hearing them during a radio broadcast) makes consumers worse off, so they must be compensated (with programming) for having experienced the ads. On the other hand, print ads in newspapers and magazines can be avoided by consumers, so these ads must make consumers better off; otherwise, no one would ever read them. Use this theory to answer the following questions: a. Think about the different types of advertisements discussed in the chapter (informative, signaling, part of the product). Which type is more likely to appear on TV? Which type is more likely to appear in a newspaper or magazine? Often you’ll see television commercials, especially for pharmaceuticals, that say: “See our ad in such-and-such magazine.” What does this say about the difference between television and print ads? b. Becker and Murphy wrote their article before TiVo and other DVR systems became popular. Nowadays, ads on television are avoidable (to a degree), just like ads in a newspaper. What impact do you think this new technology has on the types of ads you see on TV? Solution 6. a. Television advertisements tend to be less informative than newspaper or magazine advertisements. Print ads often include lots of information. Those uninformative ads, if Becker and Murphy are right, must make consumers worse off. But, as the textbook points out, these kinds of ads might actually increase the value of the good they advertise—even if the ads themselves make consumers worse off. The “see our ad” technique is employed to take advantage of the different advertising media. For example, a pharmaceutical company may want to convey lots of complicated information, but a television ad may not be the right place for this kind of information; rather, in a television spot, the pharmaceutical company wants to accomplish the task of increasing the value of the product—not necessarily creating value from the ad itself. b. If TV ads become avoidable because of DVR technology, then they will have to become ads that make consumers better off, not worse off. This can be done if TV ads contain more information (like newspaper ads), but TV ads have potential that newspaper ads don’t have: They can become as entertaining (sometimes more entertaining) than the TV programs during which they air. If advertisers start making commercials that are really funny, for example, people will want to watch them, despite their ability to fast forward, just to be entertained. New technologies such as DVRs, therefore, should cause firms to invest more in making ads entertaining. Most important, with DVRs, ads will become incorporated into the television show itself so they cannot be skipped. Did you see the ad in the American Idol photo? 7. Why do you think chain restaurants like Chili’s, Applebee’s, and TGI Fridays are always changing their menus—introducing new appetizers, new entrees, and new cocktails? Are they all just trying to find the perfect menu, or is there something else going on? 5 Solution 7. Something else is going on—these restaurants are trying constantly to differentiate themselves from one another and from other restaurants in a given market. If any of these restaurants were to “settle” on a menu and leave it unchanged, then over time any number of competitors would be able to replicate the menu and offer the same set of menu items and amenities. The constant menu rotation is a (potentially costly) way of preserving product differentiation and market power. 8. Wrigley’s spends around $30 million per year on intense, over-the-top commercials that claim to showcase what it feels like to chew 5® Gum—Wrigley’s second most popular gum brand. Despite claiming, in a tongue-in-cheek way, to provide information about the gum to viewers, it is obvious that very little information is embedded in the high-concept, visually stimulating commercials. So what is the point of the advertising? How would an economist view this type of advertising? How do you view it? Would it be better to have a perfectly competitive market in gum? Solution 8. The point of this advertising is to differentiate this product (even if only in the minds of television viewers) from the other gums on the market. No one view of this kind of advertising is universal among economists. However, some views may be more common. If this advertising doesn’t help consumers make better choices—and it is costly—then some economists might view it as a waste, particularly because it creates market power, which leads to lost gains from trade (deadweight loss). On the other hand, a competitive gum market would have more efficiency, but it would result in fairly standardized gum, with many producers all producing essentially the same product. Some economists identify the trade-off between the positive outcome of greater variety and the negative outcome of less efficiency as an important one worthy of careful consideration. 9. Many restaurants are not 100% full all day long, especially in the late morning and during the afternoon. Economists call this “excess capacity” and it is a characteristic result of monopolistic competition. What would restaurants have to do in order to be closer to 100% full all of the time? Why won’t they do this? Solution 9. If restaurants lowered their prices, they could attract more customers. They do, after all, face downward-sloping demand curves. Restaurants don’t do this, however, because they would lose money. First, having to reduce menu prices means that you are reducing the price even for the customers that are already choosing to eat at the restaurant; because a profit-maximizing restaurant already has prices as low as they can be, lowering prices any further would cause the restaurant’s profits to fall, because the additional revenue brought in (adjusted for the lost revenue of cheaper meals to extant customers) would not be enough to offset the additional cost of providing the meals. Secondly, consider the fact that the restaurant faces significant competition—this is what has driven the price down to its current level. Even though restaurants charge a markup on marginal cost (i.e., they charge you more for the food than the ingredients and labor cost them to buy), the price of the food is, in the long run, exactly equal to the average cost (including overhead and capital) of producing it. There simply is no room for the price to fall any lower.