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profit-maximizing price and quantity for a monopolist that faces demand given by P 5 100 2 Q and has constant marginal cost of production of 10 per unit. As a benchmark, note that price in a competitive market would equal marginal cost, or 10, and total industry output would be 90.

The monopolist’s total revenue is price times quantity, or 100Q 2 Q2. The corresponding marginal revenue is 100 2 2Q (see the Economics Primer for further discussion of marginal revenue). The monopolist maximizes profits by producing up to the point where the additional revenue just equals the additional cost, or where marginal revenue equals marginal cost. This occurs here when 100 – 2Q 5 10, or Q 5 45. It follows that the profit-maximizing price P 5 $55, and profits (total revenues minus total costs) equal $2,025. Note that the monopolist’s price is well above its marginal cost and its output is well below the competitive level.

This analysis shows that a monopolist’s profits may come at the expense of consumers. Policy makers often propose reining in monopolies through taxes or aggressive antitrust enforcement. The economist Harold Demsetz cautions that monopolies often result when firms discover more efficient manufacturing techniques or create new products that fulfill unmet consumer needs.9 Even at monopoly prices, the benefits that these innovations bring to consumers may be enormous. (Think of blockbuster prescription drugs, the iPad, or Google.) Demsetz argues that policies that limit monopoly profits may discourage all firms from innovating and harm consumers in the long run.

Several firms acting in concert so as to mimic the behavior of a monopolist are known as a cartel. Most developed nations have antitrust laws prohibiting private organizations from cartelizing an industry, but there are many international cartels. The Organization of Petroleum Exporting Countries (OPEC) is perhaps the best known cartel even though it accounts for only 40 percent of world oil production. Efforts have been made to cartelize other international commodities industries, including copper, tin, coffee, tea, and cocoa. A few cartels have had short-term success, such as bauxite and uranium, and one or two, such as the DeBeers diamond cartel, appear to have enjoyed long-term success. In general, most international cartels are unable to substantially affect pricing for long.

Monopolistic Competition

The term monopolistic competition was introduced by Edward Chamberlin in 1933 to characterize markets with two main features that are important to understanding pricing:10

1.There are many sellers. Each seller reasonably supposes that its actions will not materially affect others. For example, there are hundreds of retailers of women’s clothing in Chicago. If any one seller were to lower its prices, it is doubtful that other sellers would react. Even if some sellers did notice a small dropoff in sales, they would probably not alter their prices just to respond to a single competitor.

2.Each seller offers a differentiated product. Products A and B are differentiated if there is some price at which some consumers prefer to purchase A and others prefer to purchase B. The notion of product differentiation captures the idea that consumers make choices among competing products on the basis of factors other than just price. Chicago apparel retailing offers a good example. Different women tend to frequent different clothing stores, based on factors such as location and style. Unlike under perfect competition, where products are homogeneous, a differentiated seller that raises its price will not lose all its customers.

178 • Chapter 5 • Competitors and Competition

Economists distinguish between vertical differentiation and horizontal differentiation. A product is vertically differentiated when it is unambiguously better or worse than competing products. A clothing manufacturer engages in vertical differentiation when it uses stronger stitching to enhance durability. All consumers will value this enhancement, although they may disagree about how much they are willing to pay for it. A product is horizontally differentiated when only some consumers prefer it to competing products (holding price equal). The popularity of many different brands of blue jeans, at different price points, is a testament to widely diverging consumer tastes for fashion.

Demand for Differentiated Goods

Figure 5.1 illustrates horizontal differentiation based on location. The figure shows the town of Linesville. The only road in Linesville—Straight Street—is exactly 10 miles long. There is a sandwich shop at each end of Straight Street. Jimmy Johns is at the left end of town (denoted by L in the figure); Quiznos is at the right end (denoted by R). There are hungry consumers in Linesville whose homes are equally spaced along Straight Street so that 50 consumers live closer to Jimmy Johns and 50 live closer to Quiznos. For simplicity, we will assume that all 100 consumers buy exactly one sandwich, regardless of price. We also assume that consumers view the two sandwiches to be of identical taste and quality. Thus, we can focus our attention on the role of geographic differentiation as a driver of market share.

Consumers will base their sandwich purchase on two factors: price and transportation costs. Let the cost of traveling one mile equal 50 cents for all consumers (this includes gasoline and time costs). Because travel is costly, some but not all consumers will seek out the lowest price sandwich. For example, suppose that both stores initially charge $5 per sandwich so that the two stores split the market. In this case, each store will have 50 customers. Now suppose that Jimmy Johns lowers its price per sandwich from $5 to $4, while Quiznos keeps its price at $5. To determine how this will affect sales at both stores, we need to identify the location on Straight Street at which a consumer would be indifferent between purchasing from Jimmy Johns and Quiznos. Because travel is costly, all consumers living to the left of that location will visit Jimmy Johns and all living to the right will visit Quiznos.

A consumer will be indifferent between the two shops if total purchase costs (i.e., sandwich plus transportation costs) are identical. Consider a consumer living M miles from Jimmy Johns and 10 2 M miles from Quiznos. For this consumer, the total cost of visiting Jimmy Johns is 4 1 .50M. The total cost of visiting Quiznos is 5 1 .50(10 – M).

FIGURE 5.1

Sandwich Retailers in Linesville

If store L and store R both charge $5 per sandwich, then all consumers living to the left of C1 shop at store L and all consumers living to the right of C1 shop at store R. If store L lowers its price to $4 per sandwich, then some customers living to the right of C1 may wish to travel the extra distance to buy from store L. If travel costs $.50 per mile, then all customers living between C1 and C2 will travel the extra distance to save a dollar.

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These costs are equal if M 5 6; a consumer located at M 5 6 will have total purchase costs of $7 at both shops. It follows that 60 consumers will visit Jimmy Johns and 40 will visit Quiznos.

Jimmy Johns gains 10 customers from Quiznos by charging $1 less per sandwich. One would intuitively expect that as product differentiation declines in importance— in this case, as transportation costs decrease—Jimmy Johns would gain even more customers. The model bears this out. If the transportation costs equal 20 cents per mile, the indifferent consumer would live at M 5 7.5 and Jimmy Johns would get 75 customers. If the transportation cost is 1 cent, then Jimmy Johns can win all 100 customers by setting a price of $4.90.

This example shows that horizontal differentiation results when consumers have idiosyncratic preferences, that is, if tastes differ markedly from one person to the next. Location is not the only source of idiosyncratic preferences. Some consumers prefer conservative business suits, whereas others want Italian styling. Some want the biggest sports utility vehicle they can find, whereas others want good mileage. In these and countless other ways, firms can differentiate their products, raise their prices, and yet find that many of their customers remain loyal.

Of course, consumers may not switch away from a high-priced seller unless they are aware of another seller offering a better value. The degree of horizontal differentiation therefore depends on the magnitude of consumer search costs, that is, how easy or hard it is for consumers to learn about alternatives. Retailers like Jimmy Johns often rely on advertising to reduce consumer search costs. Low-price sellers usually want to minimize search costs, for this would likely boost their market shares. But low search costs reduce horizontal differentiation, leading to lower prices and lower profits for all firms. Chapter 10 describes how firms can exploit consumer search to create value and gain competitive advantage.

Entry into Monopolistically Competitive Markets

The theory of optimal pricing implies that firms in differentiated product markets set prices in excess of marginal costs. This creates a powerful competitive dynamic. If prices are high enough to more than cover fixed costs, firms will earn positive economic profits, inviting entry. Entry reduces prices and erodes market shares until economic profits equal zero. If prices are insufficient to cover fixed costs, firms will earn negative economic profits. Exit by some firms will restore the survivors to profitability.

These forces can be understood with a numerical example. Consider a market that currently has 10 firms, called incumbents. Each of the 10 incumbents has a constant marginal cost of $10 per unit and a fixed cost of $120. Each incumbent sells a horizontally differentiated product and faces a price elasticity of demand 5 2, so that the profit-maximizing price for each incumbent firm is $20.11 Suppose that at this price the total market demand is 240, which is evenly divided among all sellers in the market—each incumbent sells 24 units. This implies that each incumbent has revenues of $480 and total costs of $360, for profits of $120. These facts are summarized in Table 5.4 in the column labeled “Before Entry.”

Profits attract entry. Suppose that entrants’ and incumbents’ costs are identical and that each entrant can differentiate its product, so that all sellers have the same market share. To further streamline the analysis, suppose that after entry the price elasticity of demand facing all sellers remains constant at 2. All firms, entrants and incumbents alike, will continue to set a price of $20. Entry continues until there are no more profits to be earned. This occurs when there are 20 firms in the market, each with sales of 12. The last column of Table 5.4 summarizes these results.