Model of Imperfect Competition Suppose you were contacted by a businessman who was interested in growing corn and he hired you to assess the probability of his success. How would you do this? Well first of all we would need to know something about the anticipated costs of production. From all our previous exposure to costs we have learned that their respective curves will look as follows:

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Now that you have drawn the above graph for your client are you able to unequivocally assure him that his business venture will be profitable? No, we cannot come to that conclusion just yet, because we have not determined the market clearing price of corn. Therefore, before we meet with our client we survey the market. From our market survey we learn that due to current weather conditions that a bumper crop of corn is expected this year. In fact, in lieu of these expectations the futures market has predicted that corn prices will fall. Futures market = A market in which contracts for the future delivery of commodities are bought and sold. The contracts themselves are called futures. The contract represents an agreement to deliver or to receive some commodity at a specified price at some future time. Based on this what do we conclude? Well, actually two solutions are possible. First of all you could write a report that is based on every conceivable business situation that could prevail. This would obviously take a lot of time and your deadline for submission is near. Secondly we could create a market condition that could exist under certain situations

and estimate your probability of success given these constraints. If we did create such a model of the market what condition would we present? Obviously we are looking at a perfectly competitive market. We know this must be so because corn is a homogeneous product. We are taking the market price for our product because, there is a large number of buyers and sellers, freedom of entry and exit from this market exists, and, all participants within the market have perfect knowledge. Now applying our vast economic expertise to all this information the following model of our client’s position:

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Q In preparation for your meeting with your client you try to anticipate all the questions he may have. Such as: 1. Is he making a profit? 2. How many bushels of corn should he produce to maximize profit. 3. Why the demand curve for his product is perfectly horizontal. Finally, after several days of practicing your presentation the day of the formal performance arrives. There you sit, armed with all your data, market surveys, charts and graphs, just reeking with confidence and the knowledge that you are prepared for anything. Finally you will meet, for the first time, the owner of the firm.

In he walks, a peculiar looking chap who for some reason looks familiar. The moment he is introduced as Orville Redenbacher you know you have made a crucial mistake. You see the model we have created assumes that price is the only concern of the buyer. Is it? Some consumers may be equally concerned with the quality of the products they consume. If this is true we cannot assume that all products are homogeneous. Just by changing that one condition invalidates the model we have created. Suppose ole Orville seriously thinks that his corn is of a higher quality than all others. In fact suppose that he is able to convince consumers that his corn is gourmet corn. Does he have to compete against all the other corn growers? No! By establishing that a difference exists between his corn and other corn he has differentiated his product from all others. This corn is one of a kind. How does this change the model? Well for one thing he doesn’t have to be a price taker any longer. In this case Orville can be a price searcher, that is, he can manipulate his price until he discovers a price at which his profits are maximized. Changing prices will certainly affect the quantity demanded. At least that’s what the law of demand claims. If this is true, what does Orville’s demand curve look like? Since Orville has differentiated his product, the demand curve for his firm will be downward sloping and relatively elastic. In this case the curve is relatively elastic because there are many other substitute goods available. Unlike the case of monopoly, where only one firm represents the entire industry, in monopolistic competition there are many small firms competing for sales. From the sequence of events just described it is easy to see why producers are eager to control their products. Economic profit can result. This is what we call monopolistic competition. The characteristics are: 1. large number of independent buyers and sellers; 2. product differentiation exists; 3. the firms are small relative to the size of the market; 4. low barriers to entry exist.

Because their very existence depends on distinguishing themselves from their competitors product differentiation becomes the foundation of this model. Differentiation exists due to: 1. better service 2. more accessible 3. greater variety of brands 4. special sales - discount stores 5. advertising Providing better service is one way to distinguish your enterprise from that of your competitors. If you look at many of our retail stores you will notice they all seem to stock the same items. computer stores for instance all carry the same brand names so they can attract the same customers. Where they may differ is by the service they offer their customers. some stores only offer the manufacturers warranty while others will provide extended warrantees and “in home” service. Accessibility can refer to the geographical location of the business or the location of your product within a retail store. For example an automobile dealership located on the back streets of a small town will attract much less business than a dealership located on or near a major thoroughfare in a larger metropolitan area. This can be attributed to both the increased visibility of the business as potential customers pass the lot each day and their ability to easily get there. Variety of goods within a store may also attract more consumers. Computer stores, for example, first tried to offer exclusive products. Some stores were dedicated to only IBM products while others were exclusively Apple products. Offering an exclusive product may be an attraction when the product is new, but eventually firms realize the importance of broadening their customer base by offering greater variety. Today many stores have realized the price sensitivity of the consumer and have differentiated themselves from traditional retailers by continually offering sales or discounted prices. K-Marts, Price Clubs, and Sam’s Club now dot our landscape and offer consumers an alternative way to purchase goods. However, the most frequently used method used to differentiate our firm from all others is through advertising. Firms use anything from

simple sales flyers to very sophisticated advertising campaigns to make consumers aware of them and their products. ADVERTISING EXPENDITURES IN THE U.S., 1776-1990 (Millions of dollars) Year 1776 1800 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940

Amount $ 0.20 1.00 3.00 7.00 12.00 22.00 40.00 150.00 175.00 300.00 450.00 1,000.00 1,100.00 2,110.00 2,840.00

Year 1950 1960 1965 1970 1975 1980 1985 1988 1990

Amount 5,700.00 11,960.00 15,250.00 19,550.00 28,160.00 54,780.00 94,750.00 118,050.00 132,640.00

U.S. ADVERTISING EXPENDITURES BY MEDIA, 1987-88 (millions of dollars)

Medium Newspapers National Local Magazines Television Network Cable Syndication Local Radio Direct Mail Yellow Pages

1988 expenditures $31,197.00 3,586.00 27,611.00 6,072.00 25,686.00 9,172.00 942.00 901.00 7,270.00 7,798.00 21,115.00 7,781.00

Percent of total 26.4% 3.0 23.4 5.1 21.8 7.8 0.8 0.8 6.2 6.6 17.9 6.6

Source: McCann Erickson Inc. Newspaper Advertising Bureau (1989)

TOP 10 NATIONAL ADVERTISERS, 1988 (millions of dollars) Rank/Company Total spending 1. Phillip Moris $2,058.2 2. Procter & Gamble 1,506.9 3. General Motors Corp. 1,294.0 4. Sears 1,045.2 5. RJR Nabisco 814.5 6. Grand Metropolitan 773.9 7. Eastman Kodak Co. 735.9 8. McDonald’s Corp. 728.3 9. Pepsi Co. Inc. 712.3 10. Kellogg Co. 683.1 Source: McCann Erickson Inc. Newspaper Advertising Bureau (1989)

Under monopolistic competition we can charge higher prices because: 1. Quality differences exist - these differences can be real or imagined, and are sometimes created through our advertising. 2. Price discrimination - monopolistic competitors frequently engage in price discrimination because they are aware of the consumers’ multiple demand elasticities and how to segment the market. Multiple demand elasticities are due to differences in income-as income rises price sensitivity falls for basic necessities. Also geographic locations within the nation may differ in their pay scales. In addition, firms tend to locate where incomes are higher increasing the number of alternatives and thus making the the price elasticity of demand greater. Firms also recognize that individual tastes play a major part in determining our willingness to consume certain goods. Firms in monopolistic markets also engage in market segmentation. Since families tend to reside in communities with families of similar income level. Communities can then be identified by

household income and firms can target products for specific income levels. Firms may also segment the market based on quantity of purchase-discounts for consumption of high volumes of goods can be offered by firms since such sales lower handling costs. Perhaps the easiest way to segment a market is by geographic location-groups of consumers that are physically separated by great distances, mountain ranges or bodies of water may find themselves paying different prices for similar goods since their ability to find suitable substitute sources of these goods is limited. Within retail stores an internal form of segmentation called location can be practiced. This refers to location of goods within a store. Studies have shown that goods placed at eye level (for the average consumer) have a greater probability of being consumed than other goods. Using the model for monopolistic competition we should note that firms in this market structure operate much the same as perfect competitors. That is to say that they will also subscribe to the profit maximizing rule and produce at the point where MR=MC. If economic profits result, then due to the low barriers to entry, they can anticipate more competitors entering the industry. This entry will force prices downward eventually stabilizing at the point of normal profit.

Normal Profit

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