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Using second-degree price discrimination
Chapter 13: Monopolistic Competition: Competitors, Competitors Everywhere
for this product differentiation. For example, differences in product quality or the type of service performed can lead to differentiation. The firm’s location is another source of the differentiation. Finally, differentiation may result from interfirm differences in promotion and packaging. ✓ Easy entry and exit: A monopolistically competitive market has no barriers to entry. New firms can easily establish themselves in the market, and similarly, existing firms can easily exit the market. Typically, easy entry and exit occurs because monopolistically competitive firms have relatively small fixed costs, so existing firms don’t significantly benefit from lower per-unit production costs as compared to new firms.
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Setting Price with Many Rivals
Interfirm differentiation allows the monopolistically competitive firm to set price. Therefore, the firm determines both the profit-maximizing quantity and the good’s price. However, the degree of influence the firm has on price is limited because a large number of rival firms are producing similar products.
The degree of influence a monopolistically competitive firm has on the good’s price is dependent on the price elasticity of demand for the firm’s good. The more elastic the demand, the less influence the firm has on price, because quantity demanded is very responsive to any price change. Two factors that influence the monopolistically competitive firm’s price elasticity of demand are the number of firms, and the degree of product differentiation among firms.
A large number of firms results in consumers having a greater number of alternatives from which to choose. Therefore, consumers are more responsive to price changes. If your firm increases price, your customers are more likely to switch to one of your rivals. As a consequence, with a larger number of rival firms, the demand for your firm’s good is more elastic and you have less influence over price.
A small degree of product differentiation also results in consumers being less concerned about which firm they purchase the good from. If firms produce nearly identical products (that is, the products have very little differentiation), consumers are very responsive to any price changes that occur. Because the products are so similar, consumers simply look for the lowest price. This minimizes your firm’s ability to charge a higher price. If you
226 Part III: Market Structures and the Decision-Making Environment
charge a higher price, most of your customers simply switch to a product produced by a competitor that has a lower price. Your quantity demanded goes down a lot. As a consequence, the demand for your firm’s product is more elastic — consumers are very responsive to any price change you make.
To have the greatest influence over price, you want to have fewer rivals and produce a good that’s a lot different from what your rivals produce.
Making use of advertising and product differentiation
Monopolistically competitive firms engage in non-price competition, such as advertising and innovation.
With both advertising and innovation, you’re trying to increase the degree of differentiation that exists between the good you produce and the goods produced by your rivals. In the case of advertising, you may stress that your pizza is made from the freshest ingredients.
Innovation is also a source of differentiation. You may introduce a new type of pizza — anchovy and spinach, anyone? — to attract new customers.
Maximizing short-run profit
Because a monopolistically competitive firm produces a differentiated good, short-run profit maximization requires the firm to determine both the profitmaximizing quantity and the good’s price. Figure 13-1 illustrates short-run profit maximization for a monopolistically competitive firm.
Differentiation leads to a downward-sloping demand curve for the monopolistically competitive firm. This curve is labeled d in Figure 13-1. Because the demand curve is downward sloping, the monopolistically competitive firm must lower price in order to sell more of the good. This lower price is charged for all units of the good sold.
Marginal revenue represents the change in total revenue that occurs when one additional unit of output is produced and sold. Because the firm must charge a lower price for every unit sold in order to sell one additional unit of the good, marginal revenue is lower than the price of the last unit sold. The marginal-revenue curve, thus, lies below the demand curve, as illustrated by the curve labeled MR in Figure 13-1.
