What type of industry features a high number of firms producing highly differentiated products?

We start this chapter by looking at monopolistically competitive industries, which like competitive industries have a large number of sellers and easy entry and exit, but which differ from competitive industries because the firms sell differentiated products. Since this is the key difference between competitive and monopolistically competitive industries, we first spend some time understanding what product differentiation is, how it comes about, and what its effects are.
When different producers’ products are indistinguishable from one another, we refer to the good as homogeneous. For example, tuna caught by different fishermen are generally indistinguishable; if they were mixed together, no fisherman would be able to identify the ones he or she caught. When different producers’ versions of the same product are distinguishable and consumers care about those differences, the product is said to be differentiated. For example, there are many different brands of cat food, and cat owners have preferences about which they want to buy for their cats, so the cat food market exhibits product differentiation.
Product differentiation occurs in the markets for many consumer products and also in the markets for producer goods or capital goods. For example, McDonnell-Douglas and Boeing, the two leading U.S. manufacturers of commercial airplanes, produce wide-body jets that are substitutes from the viewpoint of United Airlines, but they are not identical aircraft.
Product differentiation sometimes happens naturally (Swiss cheese and cheddar cheese just taste different), but firms often put a lot of effort and resources into deliberately differentiating their products. A firm may be able to earn a profit by making its product distinct in some way from the products of other producers and by showing or convincing consumers that its product is better than those of the other producers.
Product differentiation helps us to understand intraindustry trade, which is the term for countries simultaneously importing and exporting the same product. Much of the trade between countries takes the form of one country exporting one good and importing another. This pattern of trade, called interindustry trade, is explained by comparative advantage; countries export the goods that they produce most cheaply and import the goods that they can produce only at higher cost. If a country simultaneously imports and exports the same good, however, it cannot be producing that good both more cheaply and at higher cost at the same time. The explanation, instead, lies in product differentiation. For example, the United States both imports clothing from France and exports clothing to France. The reason is that French fashions and American fashions are different in the eyes of consumers in both countries, so we are really importing and exporting two different products, French clothing and American clothing.
Product differentiation also helps to explain why there is so much advertising in the economy. Advertising allows a firm both to inform consumers about actual differences between its product and those of its rivals and to get people to think that there are differences between products.
As a result of product differentiation, consumers have many different versions of a product from which to choose. Making a good choice involves knowing about the alternatives, and it would be very costly for consumers to gather all the necessary information themselves by testing the products. As a result, there are consumer information services that do the testing and provide the information to consumers.
Products can be differentiated in several ways. They can be physically different, located in different places, available at different points in time, or have different degrees of convenience. For example, high-tops and low-tops, a soft drink in your refrigerator and a soft drink at the student union, the 7 o’clock showing and the 9 o’clock showing of a movie, and a can of condensed soup and a microwaveable single serving of ready-to-eat soup are all close substitutes, but are not exactly the same thing to some consumers.
From the viewpoint of the firm, product differentiation may be a profitable strategy. Producing a new version of a product can add to revenues by attracting consumers who prefer your version to those produced by other firms, but it will also add to your costs in the form of research and development costs and marketing and sales costs. We can apply the same sort of marginal revenue and marginal cost analysis that we developed in Chapter 6 to understand the firm’s decision about how much product differentiation to undertake. So long as the marginal revenue that results from an additional differentiated product outweighs the marginal cost of achieving it, then the additional differentiated product adds enough to revenue to cover the additional cost and leave something to be added to profits. On the other hand, if the marginal cost of the last differentiated product was greater than the marginal revenue, then the last product didn’t bring in enough additional revenue to cover its additional cost, and the difference has to come from profits. Cutting back on product differentiation a bit means that those funds can remain as part of profits, so profits are higher without the last product. When the firm has carried out its product differentiation efforts to the profit-maximizing level, the marginal cost of product differentiation will just equal its marginal revenue.
When products are differentiated, the demand curve for each version slopes downward, and the firms have some market power. If any firm chooses to raise its price, it loses some of its customers to the other firms selling different versions of the good, but not all of its customers, because some people prefer this particular version and are willing to pay a bit more for it. In this sense, the producer of a differentiated product is like the monopoly we studied in Chapter 10. However, in monopolistic competition, unlike in a monopoly, there are no barriers to entry or exit.
Figure 11.1 shows the demand, marginal revenue, marginal cost, and average total cost curves for a monopolistic competitor in the short run. This figure looks just like the monopoly diagram from Chapter 10. The difference is that the demand curve is for this firm’s product (e.g., Levi’s jeans) and not for the whole market (e.g., jeans). As a result, when new firms enter the industry, the demand curve for each existing firm shifts to the left as some customers buy from the new firms.

Figure 11.1
In the short run, when the number of firms is fixed, the monopolistic competitor’s decision about how much to produce to maximize profits is just like the monopolist’s. The monopolistic competitor chooses the quantity for which marginal revenue equals marginal cost and charges the price that causes consumers to demand this quantity. The profit-maximizing quantity and price are shown in Figure 11.1 as well. If that price is greater than average cost, the firm makes an economic profit. If the price is less than average cost, the firm takes a loss. In Figure 11.1, the firm is earning an economic profit.
In the long run, profits in a monopolistically competitive industry attract new entrants, just as they do in a competitive industry. Likewise, losses lead some firms to exit. So when equilibrium is reached in the long run and no more firms wish to enter or exit, the firms that are in the market must be earning zero economic profits. This means that the price equals average total cost. Figure 11.2 shows this situation. Notice that entry has caused the demand curve to shift to the left, and that in the long-run equilibrium, the demand curve just touches the average cost curve at the profit-maximizing quantity and price.

Figure 11.2 Thus, when a monopolistically competitive industry reaches long-run equilibrium, two things must be true. First, each firm must be producing the quantity for which marginal revenue equals marginal cost. If a firm isn’t producing this level of output, it is not maximizing its profits and will want to change its output level. Second, each firm’s price must equal its average total cost. If this isn’t the case, firms will be either making a profit or taking a loss, and firms will want to enter or exit.
Let’s compare the long-run equilibrium of the monopolistically competitive firm with the equilibrium of a firm in a competitive industry. You will see two things. First, since the monopolistic competitor has some market power, the demand curve for its output slopes downward; price is greater than marginal cost. This means that, like a monopoly, the monopolistically competitive firm produces an inefficient level of output. The marginal benefit of another unit of output to whichever consumer would purchase it if the price were slightly lower is greater than the marginal cost of producing that additional unit, but the monopolistic competitor doesn’t produce that additional unit because selling it would mean lowering the price to all its customers. Second, the monopolistically competitive firm does not choose to produce the quantity that is at the minimum point on the average total cost curve, so that, unlike in the competitive industry, the output is not produced as cheaply as possible. By producing a little more, the firm could take advantage of additional economies of scale and lower its costs, but again, the monopolistic competitor doesn’t produce that additional output because selling it would mean lowering the price; thus, the firm operates with excess capacity and excess costs.
When we looked at competitive markets in Chapter 7, we found that the long-run equilibrium of competitive markets had several desirable characteristics. One of the most important of these was that the equilibrium was efficient, in the sense that the sum of producer surplus and consumer surplus was maximized and there was no deadweight loss. We have just seen that the long-run equilibrium of the monopolistically competitive market, on the other hand, does involve some deadweight loss. Does this mean that competition is better than monopolistic competition? Not necessarily. Efficiency is one goal that society has, but it is not the only goal. If people value being able to choose from a variety of differentiated products, the cost of having some deadweight loss may be justified by the benefit of product diversity.
Monopolistic competition isn’t the only market structure that lies in between competition and monopoly. When there are only a few firms in a market and entry is difficult, the market is an oligopoly. The key feature of an oligopoly is that the profitability of any one firm’s actions depends on how the other firms respond to those actions. In this situation, a firm must make some prediction of how the other firms will respond to its choices when it decides how much to produce, what price to charge, how much to spend on advertising, and so on. When firms are aware of other firms’ expected responses to their choices and take those expected responses into account when making choices, they are said to be engaging in strategic behavior. There are two ways to think about strategic behavior, the game theory approach and the conjectural variations approach, and we will look at oligopoly using both of these.
Game theory is a branch of applied mathematics that studies how people behave in situations that involve conflicts. A typical game of strategy used in such studies is called the prisoner’s dilemma; the name comes from the scenario that it describes. Two suspected criminals are each offered the following bargain: If you confess and implicate your accomplice, the police will blame the entire crime on your accomplice and let you go. If both confess, they share the blame and will get half the sentence. If both refuse to confess, both will be convicted of a minor offense and get a light sentence. In this example, the best that the two prisoners can do overall is to keep quiet; in that case, they each get a small penalty for the minor offense. But each one has a strong incentive to turn in the other, for two reasons. First, if you turn in your accomplice and your accomplice doesn’t confess, you will avoid even the minor penalty. Second, if your accomplice confesses and you don’t, you end up taking all the blame. No matter what your accomplice does, you are better off confessing. So self-interested behavior leads each person to confess and get half the sentence, even though they would both be better off if they both kept quiet.
What the prisoner’s dilemma highlights is a situation in which the incentives are such that doing what is in their own self-interest doesn’t achieve the best overall outcome for the people involved. The best thing the two prisoners could do, if they could make an agreement and stick to it, would be to keep quiet; this is called the cooperative outcome of the game because it would involve working together to thwart the police. Self-interested behavior would lead them both to confess, which is called the noncooperative outcome, because it results from each person’s acting on his or her own. In a Nash equilibrium, neither player wants to change from their chosen strategy on their own; given what the other player is doing, they are doing the best they can.
What does all this stuff about the police and accused criminals have to do with oligopoly? The answer is that similar situations, in which incentives arise that prevent self-interested individuals (or firms) from achieving the best outcome for the group, are common in economics. Suppose we change the story, so that instead of two accused criminals, we have two firms in a market for a homogeneous product. Such an industry is called a duopoly, and it is the simplest type of oligopoly to study. Suppose the two firms’ choices are to charge the monopoly price or the competitive price. If they both charge the monopoly price, they each get half of the customers and half of the monopoly profits, and if they each charge the competitive price, they each get the competitive profit, which is zero (the firms are not going broke, but are earning only the normal rate of return on their capital). But if one charges the monopoly price and the other charges the competitive price, the high-price firm gets no customers and takes a loss, whereas the low-price firm gets all the customers and, say, three-quarters of the monopoly profit.
This situation has the same structure as the prisoner’s dilemma. The cooperative outcome, which is the best that the two firms together can do, is to make the monopoly profit and share it. The monopoly profit is, after all, the most profit that could be earned in this market if it were controlled by a single firm. There are several ways in which the two firms could achieve the cooperative outcome. First, they could engage in explicit collusion by making an agreement to charge the monopoly price and sticking to it. A group of producers who make an agreement about prices (or outputs) like this is called a cartel; as we will see in Chapter 16, it is illegal in the United States. Second, one firm could decide to match what the other firm did, and if the other firm charged the monopoly price, they would both share the monopoly profit; while there is no actual agreement between the firms and therefore no cartel, the result is the same. This is known as tacit collusion. The dominant firm in this case is sometimes called a price leader. Finally, the two firms could actually merge and become a monopoly, in which case the new firm will charge the monopoly price and earn the monopoly profit. Again, as we will see in Chapter 16, this merger would probably be illegal in the United States.
If the two firms cannot achieve the cooperative outcome by a cartel agreement, tacit collusion, or merger, they both have strong incentives to charge the competitive price. First, if the other firm charges the monopoly price and you charge the competitive price, you get all the customers and earn more profit than you would if you charged the monopoly price too. Second, if the other firm charges the competitive price and you don’t charge the competitive price as well, the other firm gets all the customers and you take a loss, which can be avoided by charging the competitive price. No matter what the other firm does, you make a larger profit by charging the competitive price than you make by charging the monopoly price.
Actually, those incentives to charge the competitive price are still strong even if the firms have entered into a cartel agreement to charge the monopoly price, but in this case lowering the price means cheating on the other members of the cartel. That is why cartels are so unstable; even though it is profitable for firms to agree to raise their prices together, it is even more profitable to lower your price after the other firms raise theirs.
Although the prisoner’s dilemma situation in the duopoly leads to a bad outcome for the two firms (they end up charging the competitive price and earn zero economic profits, when it might be possible for them to act cooperatively and earn the monopoly profits), you need to remember that this is good for society. Consumers benefit from the lower price, and we know that deadweight loss is reduced by competition.
If the two firms in the duopoly are going to interact in the market year after year, they may be able to avoid the noncooperative outcome. The reason is that if one firm cooperates now (by charging the monopoly price), the other firm can reward it by cooperating in the future, and if one firm defects now (by charging the competitive price), the other firm can punish it by being noncooperative in the future. A strategy of always choosing this play what your rival did last play, which is called a tit-for-tat strategy, has this reward-or-punish effect, and can lead to cooperation even though neither player is choosing to act cooperatively. A firm that has a reputation for being cooperative has a lot to lose if it stops cooperating, because that reputation is valuable. Thus, the outcome of the prisoner’s dilemma game can be quite different depending on whether the game is going to be played once or repeatedly by the two players.
The incentive for firms to cheat on a cartel agreement also depends on how difficult it is for the other firms to detect their cheating and punish it. If a firm can lower its price and steal some customers from its fellow cartel members without their knowing it, it is more likely to do so. Cartels often look for methods to make their pricing public, so that it is easier to observe cheating and respond to it. This deters firms from acting noncooperatively and cutting prices.