Substantial Incomes – Wealth Creation

Perfectly Elastic Demand - a situation in which any price increase above the market price will cause a firm’s sales to fall to zero; represented by a horizontal demand curve.

Monopolistic Competition - a term describing industries that consist of many small firms, where entry to the industry by new firms is easy, and where the products or services or individual firms, while basically similar, are differentiated from each other to a degree.

Product Differentiation – attempts by individual firms to distinguish their product(s) or service(s) from those of their competitors.

Laissez-Faire - the doctrine, or philosophy, that it is neither necessary nor beneficial from the viewpoint of the public interest for governments to intervene in the operation of the economy.

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In the previous topic we examined competitive industries, in which there are many firms in the industry and it is easy for new firms to enter the industry. As a result, competition in such industries is particularly strong, and is constantly pushing downwards on profits. Such a situation benefits the consumer, but certainly not the producers, who probably wish that they were fewer in number and could somehow prevent (or at least regulate) the entry of new firms into the industry. Then they would be in a position to restrict the supply of the product and (if demand were inelastic) increase their revenues. However, the difficulties in organizing such numerous producers to act collectively, plus the impossibility of preventing new firms from entering the industry, make it impossible for producers in competitive industries to achieve this. In short, then, the major problem facing producers in competitive industries is that they are unable to control the supply and therefore the price of their products. Such industries are divided into two categories – monopolistic industries, in which there is only one producer, and oligopolistic industries, which are dominated by a few large producers.

Note that we say “revenues,” not “profits.” At this point, we are not including in our discussion how the production costs of business firms interact with their sales revenues to determine their profits – this will be done in Chapter 11.

From Greek words meaning “one seller” for monopoly, and “few seller” for oligopoly. Quite possibly the single most misspelled word in the entire field of economics is “oligopolistic.”

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Services (such as dry cleaning) emphasize the speed of service, others stress quality, others offer extended hours. To the extent that a firm is successful in these efforts at product differentiation, it can alter its demand curve by making it more inelastic. For instance, Harry’s competitive position would be enhanced strongly if his were the only hamburger stand in a prime location, or if he developed a unique and highly popular product line. On the other hand, a monopolistic, competitive market is a very dynamic situation, and Harry must face the risk that his competitors – or a brand new firm starting up – may successfully imitate his advantages, reducing the degree to which Harry’s firm is differentiated, and making the demand for his hamburgers more elastic again. Worse yet (from Harry’s viewpoint), some of them may come up with even better ideas to differentiate their products, placing Harry at a disadvantage. People who have operated small businesses successfully in this kind of environment for years tend to discount flashy promotional “stunts” as short-term strategies, and stress instead the importance of establishing (or earning) a reputation as an honest, reliable firm, if long-term success is to be achieved. They claim that this is the most valuable type of product differentiation that a firm can achieve.

In conclusion, product differentiation, however achieved, can benefit the firm in two ways. First, it can build consumer loyalty to the firm and its products, and thus protect the firm against competition, and second, it can provide an opportunity for the firm to charge higher prices for its products, to the extent that consumers believe the product differentiation to be worth a higher price. All firms welcome the advantages of consumer loyalty; some will also charge a higher price while others will not. Thus, product differentiation introduces into a situation that is basically very competitive a slight degree of monopoly power, due to the fact that each firm’s product or service can be different from those of its competitors. Obviously, the degree to which this occurs varies: it is one thing to be the only one of eight hamburger stands in town with a particular location, and quite another to be the only Chinese restaurant in town and the only restaurant with a liquor license. Nonetheless, new restaurants can easily open, emphasizing the fact that, while monopolistic competition is less extremely competitive that perfect competition, it still represents a highly competitive situation. As a result, profits in monopolistically competitive industries generally tend to be low, with many firms earning only marginal profits. However, firms that enjoy cost advantages, or that have succeeded in practicing product differentiation to their advantage, will earn above-average profits.

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Perfect Competition

1. many firms
2. easy to enter
3. identical products

Prices and profits are held down, and producers have no control over the price of their product.

Economic incentive for each producer is to

(a) maximize efficiency (minimize production costs per unit),

(b) produce as much output as is economical, and

(c) sell it for whatever price the market establishes.

Monopolistic Competition

1. many firms
2. easy to enter
3. differentiated products

Prices and profits are held down, but producers have a small degree of control over the price of their product.

Economic incentive for each producer is to

(a) maximize efficiency (minimize production costs per unit),

(b) practice product differentiation, and

(c) (possibly) increase price by a small amount only.

Non-Competitive Industries

1. few firms
2. difficult to enter

Prices and profits tend to be higher than in the competitive situation.

Economic incentive for all producers is to act together so as to restrict competition and raise prices significantly.

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That is, practice product differentiation – it can increase its ability to raise prices (within limits) without losing too many sales.

For instance, Harry’s Hamburg Stand is a firm in a monopolistically competitive industry (fast foods) comprised of a large number of small outlets, each with its own characteristics such as product, service and location. Harry’s Hamburg Stand is differentiated by its location (between the beer store and the drive-in theater), its product (Harry’s hamburger are not prepackaged, but charbroiled and dressed to the customer’s taste), its service (Harry’s employees are known to be very polite and efficient), and the fact that Harry was the highly popular penalty leader for the local hockey team for several years. At a price of $1 per hamburger (the same price charged by most others in the area), Harry sells 2000 hamburgers per week, as indicated by the dot on the diagram. The demand curve is quite elastic, due to the competitiveness of the industry, but around the market price of $1, it is less elastic, due to the fact that Harry’s is differentiated from his competitors. For instance, Harry could raise his price a little (say, to $1.10) without losing many sales. While some of his customers would abandon him, the vast majority would stay him. Although not happy about paying the premium, they would feel that the combination of location, product and service made Harry’s hamburgers worth a little more. Thus, for a small price increase, the demand for Harry to raise his price a little. However, if Harry were to raise this price by much (say to $1.20), he would likely find that the demand for his burgers are not worth the extra $.20 each and switch to other hamburg stands, causing Harry’s sales (and profits) to try or not. As we have said, perfect competition is a rare situation because of the requirement that products be identical; however, monopolistic competition is a very common form of market structure that includes most of the small business sector of the economy discussed earlier. Taken together, competitive industries probably account for roughly two-fifths of the economy’s output, concentrated for the most part in some sectors of agriculture and fishing, retail trade, small-scale manufacturing and especially the large number of service industries (restaurants, fast-food outlets, travel agencies, and so on) that have expanded rapidly in recent years. Figure 9-5 summarizes the characteristics of the two types of competitive industries we have been considering, together with the incentives that each situation provides to producers. For comparative purposes, a brief summary of non competitive industries, which will be examined in Chapter 10, is also included.

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As in perfect competition, there is a strong incentive for producers in monopolistic competition to strive to increase productive efficiency: faced with very little scope for increasing prices, firms in this situation find it very important to produce at the lowest possible cost per unit. Under monopolistic competition, however, there is the additional incentive to practice product differentiation, so as to widen the difference between your product and your competitors’, and thus gain an advantage in the marketplace. This could be achieved by actually making your product or service different from those of your competitors’ and by trying to persuade consumers that whatever differences exist are of importance to them.

Accordingly, we can expect sellers in monopolistically competitive industries to use considerable ingenuity and advertising and promotion to establish the ways in which they are different from their competitors – which they do. Restaurants stress their special menus, drinks, atmosphere, type of entertainment and so on. Retailers strive to establish their own “identity” through the character of their shops, special product lines, special services (delivery, exchanges, refunds, credit and so on).

This is not to say that Harry will raise his price to $1.10, only that he could. Harry’s problem is that he doesn’t know how far he can raise his price without losing too many sales; as a result, he is likely to be cautious about increasing his price. Many firms in this situation would decide to charge the same price as their competitors ($1.00), rather than  risk a price increase that could have negative effects on their sales and profits.

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At prices above $1.20, not even his mother will eat at Harry’s. Thus, under monopolistic competition, the fact that each firm’s product is somewhat different from its competitors’ can give it an opportunity to raise its price a little.

A similar effect occurs with price reductions: while large price reductions will attract many sales, for small price reductions demand will not be so elastic. A small price cut by Harry will not likely attract many more customers from his competitors…these customers are patronizing Harry’s competitors because they prefer their products, location or other features, and will not likely be lured away by the prospect of saving five or ten cents per burger at Harry’s. A large price cut is out of the question – while it would increase Harry’s sales greatly, he would lose money on every sale and go bankrupt.

In summary, then, the demand curve for the differentiated product of a firm in monopolistic competition is basically very elastic, but for small changes around the market price, it it less elastic, and possibly even inelastic. As a result, the firm has the opportunity to increase its price, within quite narrow limits, although it may or may not decide to actually do so.

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• New products that have not yet been introduced. Many computers companies have regretted sharing this type of information with customers. If a product on the drawing board is smaller, better, and cheaper, then why would a customer buy the existing product?

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