Pricing coupons

Chapter 13: Monopolistic Competition: Competitors, Competitors Everywhere

Because the firm is earning positive economic profit, new firms enter the market. The entry of new firms causes the original firm’s demand to decrease to dLR as some of the firm’s customers switch to the new firms. The decrease in demand causes marginal revenue to decrease to MRLR. The resulting new profit-maximizing quantity is qLR and price is pLR. At this point, price equals average total cost, as represented by the demand curve being just tangent to the average total cost curve. Because price equals average total cost, firms earn zero economic profit, and new firms no longer have incentive to enter the market.

The determination of economic profit includes all costs associated with the good’s production, including the opportunity cost of resources contributed by the firm’s owner. Zero economic profit indicates that the firm’s owner is receiving exactly as much as the owner would receive in the next best alternative. In other words, the owner is receiving a normal rate of return.

As is illustrated in Figure 13-2, although price equals average total cost in monopolistic competition’s long-run equilibrium, average total cost isn’t at its minimum. Because average total cost isn’t minimized, monopolistically competitive firms are characterized by excess capacity. This excess capacity simply means the firm can produce greater output at lower per unit cost. However, selling this larger amount of output would require the firm to lower price on all units resulting in negative profit. (Note that at the quantity of output associated with minimum average total cost, price off the demand curve is below minimum average total cost.)

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Determining the Ideal Amount of Advertising

One factor contributing to product differentiation in monopolistically competitive markets is advertising. Determining the appropriate or profit-maximizing level of advertising is crucial to the firm’s success.

Advertising’s affect on consumer taste and preferences enables it to influence consumer demand for a product. For the monopolistically competitive firm, an increase in advertising increases demand for its product, while a decrease in advertising decreases the firm’s demand. However, in addition to shifting demand, you must recognize that changes in advertising expenditures affect your cost.

Advertising increases your profit as long as the marginal revenue obtained through the sale of additional units is greater than the marginal cost of producing those units plus the cost of the additional advertising expenditures.

232 Part III: Market Structures and the Decision-Making Environment

Mathematically, the additional profit that’s made through the production and sale of one additional unit of output is price minus marginal cost, P – MC. The change in gross profit that occurs with an additional dollar spent on advertising equals the change in the quantity sold that occurs, Δq, multiplied by P – MC. This amount is gross profit, because it doesn’t include the cost of advertising. The monopolistically competitive firm’s net profit increases as long as each additional dollar spent on advertising generates more than an additional dollar’s worth of gross profit. In other words, net profit increases as long as

In order to maximize the net profits associated with advertising, the firm should continue increasing advertising expenditures until

At this point, an additional dollar’s worth of advertising adds one dollar to gross profit, resulting in no gain in the firm’s net profit.

Here I manipulate the previous equation to derive a very important relationship. If you want to skip the manipulation, that’s fine. Go straight to the result, and take my word for it, the relationship really works.

If you take the previous equation and divide both sides by (P – MC), you get

Now, multiplying both sides of the equation by P yields

At the point of profit maximization, marginal revenue equals marginal cost. Substituting MR for MC in the equation leads to

Chapter 4 shows that the right side of this equation equals the negative price elasticity of demand, η, for the firm’s product. The left side of the equation represents the marginal revenue of an additional dollar’s worth of advertising. Therefore, the optimal level of advertising expenditures corresponds to