Chapter 17

1. Entry of firms in a monopolistically competitive industry is characterized by two "external" effects. List these effects (The product-variety externality and The business-stealing externality) and briefly describe in detail how consumers and incumbent firms are influenced by these externalities.

Those “external” effects are The Product-variety externality and Business-stealing externality. Now let us describe them.

Product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers. This externality arises because a new firm would offer a product different from those of the existing firms.

Business-stealing externality: Because other firms lose customers and Profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms. This externality arises because firms post a price above marginal cost and, therefore, are always eager to sell additional units

2. Assume the role of a critic of advertising.

1)Firms advertise to manipulate people’s tastes. Many advertisements are psychological rather than informational. For example, advertising of Fanta, by that advertisement they give message which is not said in advertisement “If you drink Fanta you will be happy and have many friends, life will be better”

2)We critics think argue that advertisement impedes competition. Firms convince seller that products are more different than they truly are. After that people are less concerned with price differences among similar products. And elastic demand curve causes all firms to charge a larger markup over marginal cost.

Assume the role of a defender of advertising.

1)Advertising gives information about products in the market. And prices for that product are shown in advertisement. So customers will be more informed about product in the market. It helps customers to make better choice in buying the particular product.

2)We also argue that advertisement fosters competition. Because as we said many people will be informed of products in the market so people will buy product concerning the price differences. It attracts another firm to enter the market and customers of existing firms will have another variant of product. Thus firms will have lower market power.

3. How does the long-term equilibrium in monopolistic competition differ from the long-run equilibrium in perfect competition? Use graphs to demonstrate why a profit-maximizing monopolistically competitive firm must operate at Excess Capacity and Markup over Marginal Cost. Explain why a perfectly competitive firm is not subject to the same constraint.

First differences: MCF produce at the tangency of demand and ATC, where the ATC is only declining, unlike the PCF which produces at the minimum of ATC. In the long run firms in monopolistically competitive market operate at the excess capacity because of it production below the efficient scale in the point when the ATC curve decreases. It do so because it were need to cut it prices to produce more units, so it’s more profitable produce at this level, unlike with perfectly competitive market, who doesn’t care.

Second differences: For a monopolistically competitive firms price exceed MC because firms always have some market power. In the long term equilibrium the market operate at the zero profit, it tell us that the price equals ATC. Thus for MCF which operate on the declining portion of the ATC price might be above MC, in order to gain profit, unlike the PCF which operate on the minimum of ATC.

Because: MCF need to cut it price to produce more, unlike with perfectly competitive market, who doesn’t care (P=MC)For a PCF profit from the additional unit sold is zero, unlike for the MCF is not.

4. For many years, Pepsi operated a "taste test" booth at local fairs across the United States. Visitors to the booth would be encouraged to take a blind "taste test" between Pepsi and its primary market competitor, Coke. Pepsi then used the taste test results in advertising Pepsi. What advertising theory does such an approach support? Pepsi no longer uses this as an advertising strategy, but rather, relies on celebrity endorsements and other forms of advertising. What advertising theory do you think now dominates the market between Pepsi and Coke? Explain.

What advertising theory does the “taste test” of Pepsi support?

Advertising may be seen as the Signal of Quality. By making the taste test across the country, and then publishing the results. People may think like: If so many people try it, and assume it as the better then another ones. It should be better, I must try it. And through this advertising Pepsi say: Our product is best product, we are better then, for example, Coke.

What advertising theory dominates between Pepsi and Coke?

I think it is Brand Name theory. Because as you can go to the typical store you usually find Pepsi or Coke, in a similar quantity as the worldwide recognized brand names. Both of this product spends large amount of money on advertising, even by use black advertising, and have an incentive to maintain quality to safe his name.

5. In the absence of price signals, communist countries rely on brand names to signal market "value." Briefly discuss how brand names (or trademarks) can be used to discipline manufacturers in command and control type economies. As part of your answer, explain how brand names improve economic efficiency. (Case study)

Advertising is related to brand names. Some firms sell products with widely recognized brand names, other sell substitutes. Firm with brand name spends more on advertising and charges a higher price. Critics argue that brand names cause consumers to perceive differences that do not really exist. Generic good is indistinguishable from the brand-name good. Consumers’ willingness to pay more for the brand-name good, these critics assert, is a form of irrationality fostered by advertising. Brand names are way for consumers to ensure that goods are of high quality. Brand names provide consumers with information about quality when quality cannot be easily judged in advance of purchase. Brand names give firms incentive to maintain high quality because firms have financial stake in maintaining reputation of their brand names. Brand names are result of irrational consumer response to advertising. Consumers have good reason to pay more for brand-name products because they can be more confident in the quality.

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