I. Monopolistic Competition

A. Characteristics



1. Firms have market power - the ability to raise price profitably above MC.



2. Firms make zero economic profits



3. Firms face downward sloping residual demand curves due to differentiated products.



4. Downward sloping residual demand curve means firm has market power.



B. Two types of models



1. Representative consumer model - all firms compete equally for all consumers who typically buy from each firm (restaurants).



2. Spatial or location models - each customer prefers products that have certain characteristics or are sold by firms located near them and is willing to pay a premium for those preferred products.

II. Product Differentiation

A. Key Concepts



1. Products are different because consumers think they are different (i.e. Tylenol vs. Osco Brand Ascenomenophen (SP?)



2. Pricing of one brand exerts a greater constraint on another brand's pricing when the two brands are close substitutes than when they are not.



B. Two approaches to analyzing differentiation



1. Consumers have preferences regarding commodities.



2. Consumers have preferences regarding attributes or characteristics of commodities (Lancaster 1966)





Cereals = More sugar --------- Less Sugar

Captain Crunch Shredded Wheat



C. Demand Curve facing individual firm in monopolistic competition is



1. Downward sloping.



2. Dependent on prices of each rival product.

III. Representative Consumer Model

A. With undifferentiated products, its the same as the Cournot oligopoly model but there is free entry.



Q(p) = 1000-1000P

C(q) = .28q+F



MC = .28 AC = .28 + F/q



Entry condition - firms enter if profit > 0



To find # of firms



1. Determine Cournot Output for each possible # of firms

2. Pick one in which firms make zero profit



OR



Set P=AC and solve for N

Cournot with N firms F=6.40





# of firms	Firm output	Price	Firm profit
	720/(n+1)	(.28n+1)/(n+1)	518.4/(n+1)^2-F
1	360	64	123.2
2	240	52	51.2
3	180	46	26
4	144	42.4	14.34
5	120	40	8
6	102.9	38.3	4.18
7	90	37	1.7
8	80	36	0
9	72	35.2	-1.22





To derive formulas, we get



n identical firms



q1(p)=Q(p)-(n-1)q2



profit1=(1-.001Q)q1-.28q-F

profit1=(1-.001(q1+(n-1)q2))q1-.28q1=q1-.001(q1)²-.001(n-1)q1q2-.28q1-F

dprofit1/dq1=1-.002q1-.001(n-1)q2-.28=0

.72-.001(n-1)q2=.002q1



know that q1=q2 in equilibrium



.72=.002q1+.001(n-1)q1

.72=.001(q1)(n-1+2)

.72(1000)/(n+1)=q1

q1=720/(n+1)

industry output = Q=720n/(n+1)



To find price:



Q=1000-1000P

720n/(n+1)=1000-1000P

1000P=1000-720n/(n+1)

P=1-720n/1000(n+1)=(1000(n+1)-720n)/1000(n+1)=(.28n+1)/(n+1)



To find profit:



profit1=(1-.001Q)q1-.28q-F

profit1=(1-.001nq1)q1-.28q1-F=.72q1-.001nq1²-F=.72(720/(n+1))-.001n(720/(n+1))²-F=

518.4/(n+1)-518.4n/(n+1)²-F=518.4/(n+1)²-F



The other method is to find N directly by setting P=AC



(.28n+1)/(n+1)=.28+6.40/(720/(n+1)), multiplying both sides by n+1



.28n+1=.28(n+1)+6.40/720(n+1)², multiplying out we get

1-.28=.0089n²+.0178n+.0089, dividing by .0089 and moving to one side we get

0=n²+2n-80=(n+10)(n-8)



n=8



According to Table 8.2 p. 293, if fixed costs are $1.60, 17 firms will be in the industry. Thus, the lower the fixed costs, the higher the equilibrium number of firms. Lower fixed costs lead to higher profits which lead more firms to enter. (Fixed costs don't affect output decision of price.)



B. Representative Consumer Model with Differentiated Products



1. Same as before but a firm's residual demand curve depends on the individual quantities produced by each of its competitors rather than on just the total quantity.



P_i=a-b_iq_i-b₂q_j(j/=I)



2. Results



A. price is above MC

B. product differentiation



1. Highly desirable products may not be produced even though P>VC if fixed costs are so great that firms lose money - too little variety.



2. Offsetting force - when firm introduces new brand it ignores the effect of its increased competition on the profits of other firms = thus they tend to produce too many products from social optimal.

IV. Location Models - consumers view each firm's product as having a particular location in geographic or product (characteristic) space.

A. Hotelling's Location model (1929)



1. Long narrow city with only one street of a fixed length

2. Customers are uniformly distributed along this street and all customers are identical except for location.

3. Each customer buys 1 quart of milk from nearest store

4. Two stores sell identical bottles of milk



| A | X | Y | B |

---

Store 1 I Store 2



For customer I, if x < y go to store 1

If y<x go to store 2

If x=y indifferent



Given that store 2 is located b miles from the end of town, where should store 1 locate? (Just to the left of store 2) - analogy to product characteristics and politics.



What if store 2 could costlessly relocate, where would it move? (To the left of 1)



Where do both firms end up? (In the middle of town)



NOTE: Bertrand Model can have P> MC if there are heterogenous products.



B. Salop's Circle Model - not covered